ISO / NSO

Stock options grant the right — but not the obligation — to purchase a specified number of shares at a fixed "strike price" on or before an expiration date. The two main flavors in US startups are Incentive Stock Options (ISOs), available only to employees and subject to annual caps, and Non-Qualified Stock Options (NSOs or NQOs), available to employees, consultants, and directors without those limits.

ISOs offer a potential tax advantage: if the holding rules are met (generally, shares held two years from grant date and one year from exercise), gains may qualify for long-term capital gains rates rather than ordinary income. NSOs trigger ordinary income tax at exercise on the spread between the strike price and the fair market value — regardless of whether the shares can be sold.

Illustrative example: an employee holds 50,000 NSOs with a $2.00 strike price at a company whose 409A fair market value is $8.00. Exercising all 50,000 creates a $300,000 taxable spread ($6 × 50,000), reported as W-2 income, due in the year of exercise — even if the shares cannot be sold for months or years.

The gotcha for pre-IPO holders: the "exercise and hold" strategy (exercise early, start the capital-gains clock) works well only if the company actually achieves a liquidity event. Exercising and then watching the company fail means paying tax on phantom value that never materialized. Timing the exercise relative to 409A valuations and expected liquidity is a real planning decision, not a formality.