What are non-qualified stock options?

If you are looking into different options for employee compensation, you have probably stumbled across the term non-qualified stock options. Chances are, you don’t quite understand what they are or what the difference is between qualified and non-qualified stock options - but we are here to help!

In this article, we are explaining in simple terms what non-qualified and qualified stock options are, how they are different, and generally explore the pros and cons of giving equity to your employees.

Some employers offer their workers shares in their company as part of their compensation package. In general, there are two options for this: qualified stock options and nonqualified stock options.

Non-qualified stock options (NSO) allow employees to purchase stocks in their employing company at a predetermined price. This is usually set at the current market value of the stock at the time of the offer. Since share prices are expected to increase over time, employees can often acquire stock options for a discount.

The employee will have to pay income tax on the difference of the grant price and the price they are paying for their shares. Furthermore, if they wait too long to make a decision on buying the NSO, they will lose the option. 

It is also fairly common to include a so-called clawback provision, meaning that the company reserves their right to cancel the option, e.g. when the employee leaves the company before a predetermined date.

Another option for equity compensation for employees are qualified options, also known as incentive stock options, or ISO. There are two main differences between NSO and ISO:

• ISO can only be granted to employees, whereas NSO can be given to employees as well as directors, contractors and others.

• ISO can have tax benefits in comparison to NSO. The employee won’t have to pay taxes when buying the shares, and if certain requirements are met, the ISO also qualify for a lower tax rate.

Giving employees shares in a company is a great way of investing into both your worker’s and your company's future. But it also comes with a lot of regulatory expenditure and is quite a complex setup, that more often than not requires additional legal and financial support.

The Pros: Loyal employees and more flexible funds

Giving shares to your employees is a great way to boost their motivation and their loyalty to your business. All of a sudden, their success in their respective role within the company can have a direct impact on how well the stocks are performing - and essentially how much money they will make from them. 

In addition to that, stock options often come with a clause that only allows shares to be paid out after a certain period of time. This can have a positive effect on your employee’s loyalty, making them want to stay with the company for a long time and investing their effort into the businesses future success.

Finally, giving equity to employees is a great option for start-ups and young businesses that simply don’t have the funds yet to pay the best talent in their industry accordingly. Offering stock options can therefore reduce the amount of money you have to spend on salaries, while still attracting qualified professionals.

The Cons: Too many cooks spoil the broth

Stock options also come with a lot of challenges. Setting them up can be a very complex system and require the support of experienced lawyers and financial advisors. These professionals must be paid, therefore reducing the gained financial flexibility by offering stock as part of a salary to employees.

Additionally, giving employees shares in your company forces you to open your books and share sensitive information with them. This might cause some internal issues, as employees could start pressuring you to sell or get in the way of future sales to other shareholders. 

Lastly, there is always a risk of giving away too much of your company and losing control about future decisions with too many people having a say in what you do.

It is crucial to thoroughly weigh the pros and cons of giving equity to employees before you make your final decision. The most important thing to keep in mind is that you are not making a decision for now, but for your business's future. Calculations of best and worst case scenarios and conversations with experienced business advisors and lawyers can help lay the foundation for a qualified decision.