• NQSOs are another common form of equity compensation.
• NQSOs are only valuable if the company stock price exceeds the employee’s Exercise Price.
• Upon exercise, the full value is taxable as ordinary income.
• NQSOs have leverage, which creates risk, but also substantial upside potential.
• Employees holding NQSOs have the ability to control the timing of taxation (to the extent of the Expiration Date).

Non-Qualified Stock Options (NQSOs) provide an employee with the ability to purchase company stock at a fixed price. The number of shares eligible for purchase and the fixed purchase price (Exercise Price) are specified in the award agreement.

NQSOs become valuable if/when the company stock price appreciates beyond the Exercise Price. In this scenario, the employee has the right to purchase company stock at the lower Exercise Price. In turn, they have the ability to immediately sell the purchased shares at a profit.

Conversely, NQSOs have no value if the company stock price is lower than the Exercise Price. In this scenario, the employee would be better off purchasing company stock on the open market at the current Fair Market Value opposed to purchasing shares at the higher Exercise Price.

The date on which the NQSOs are awarded to the employee. On this date, the employee will receive documentation confirming the award, the number of options, Exercise Price, Expiration Date, vesting details, and other relevant information.

Vesting is the process by which granted NQSOs become eligible for Exercise. Prior to this date, NQSOs cannot be acted on by the employee. 

The time period over which NQSOs vest. There are two common types of vesting schedules.

• Cliff Vesting: When the full award vests at one time.
• Graded Vesting: When a portion of the award vests incrementally over time. For example, 25% of the award vesting per year over 4 years – OR – 33% of the award vesting per year over 3 years.
• Generally speaking, Graded Vesting is the preferred structure of vesting due to the employee receiving access to a portion of the award sooner. For example: An employee receives a 1,200 NQSO award on 2/1/2022, but leaves the company on 6/1/2024.
• • • Under a 3-Year Cliff Vesting Schedule: The employee would have received 0 of the 1,200 NQSOs. This is due to the full 1,200 NQSOs being slated to vest on 2/1/2025.
    • Under a 3-Year Graded Vesting Schedule: 800 of the 1,200 NQSOs would be vested and exercisable; 400 vested on 2/1/2023 and 400 vested on 2/1/2024. They would have forfeited the final 400 NQSOs, which were slated to vest on 2/1/2025.

The process of purchasing NQSOs. Upon exercise, the NQSOs simply become shares of company stock that the employee can retain or sell (subject to trade window restrictions).

This is the fixed price the employee can purchase the company stock at, regardless of the Fair Market Value on the date of exercise.

The date when the employee chooses to sell the exercised shares, turning them from company stock into cash. From here, the employee has several options for allocating the sale proceeds (net of any corresponding tax liability). Considerations include retaining in cash savings, pay down debt, earmark for upcoming expenses, invest for growth, gift to charity, etc.

The date when the employee’s ability to purchase/exercise the shares expires. It is important to be mindful of this date to avoid valuable (“In the Money”) NQSOs expiring worthless.

Let’s explore how NQSOs work with an example. The below chart summarizes an employee’s hypothetical stock option awards over multiple years, assuming the current Fair Market Value of the company stock is $115/share.

• How is “Total Value “Calculated?
  • Formula: (Current Fair Market Value – Exercise Price) x Number of Options
  • Looking at Lot 1: ($115.00 – $89.09) x 6501 = $168,440.91
• As you can see, the Lots where the $115/share Fair Market Value exceeds the Exercise Price (Lot 1, 2, & 5) have a positive “Total Value”.
• Conversely, the Lots where the $115/share Fair Market Value is lower than the Exercise Price (Lot 3 & 4) have no value.
• This hypothetical illuminates a core concept of NQSOs: There is only value if the stock price is appreciated beyond the Exercise Price.
• Lastly, it is important to highlight that NQSOs are “Appreciation Only” awards. Using Lot 1 as an example, the employee’s value is simply the appreciation beyond the $89.09 Exercise Price ($115.00 – $89.09 = $25.91) multiplied by the number of Options (6501 options x $25.91 = $168.440.91).

A key feature to understand is the concept of leverage, which is inherent in NQSOs. Leverage means a small percentage increase in the stock price can result in a disproportionately larger increase in NQSO value. Simply put, a 10% increase in the stock price will increase the value of NQSO by more than 10%.

Expanding on the previous example, assume the Fair Market Value increases by 10% from $115.00/share to $126.50/share.

• A 10% increase in the stock price resulted in:
  • Lot 1 value increasing by 44%.
  • Lot 2 value increasing by 65%.
  • Lot 3 value moved from no value (“Out of the Money”) to having value (“In the Money”).
  • Lot 4 still has no value; “Out of the Money”.
  • Lot 5 value increasing by 288%.
• The closer the Exercise Price is to the Fair Market Value (smallest initial spread), the more embedded leverage. The Lot 5 example shows how a small initial spread between $111.01/share and $115/share means even a modest price increase creates a substantial percentage gain relative to the starting value.

While leverage can be favorable at times, it is important to remember it can also be unfavorable. Meaning, while the previous example highlighted how a 10% increase in the stock price will increase the value of NQSOs by more than 10%, the inverse is also true. See below, which illustrates a 10% reduction in Fair Market Value from $115.00/share to $103.50/share.

• A 10% decrease in the stock price resulted in:
  • Lot 1 value decreasing by 44%.
  • Lot 2 value decreasing by 65%.
  • Lots 3 & 4 still have no value; “Out of the Money”.
  • Lot 5 decreasing by 100% (no value).
• Therefore, it is important to remember leverage goes both ways.

Taxation first occurs at the time of exercise, not when they are granted or vest. The Vest Date simply provides the employee the opportunity (but not the requirement) to purchase shares. Said differently, the Vest Date does not automatically provide the employee with shares or value, and therefore, it’s not a taxable event.

Taxation at Exercise:

When you exercise, the “bargain element”—the difference between the stock’s Fair Market Value and your Exercise Price—is taxed as ordinary income. This triggers mandatory federal, state (if applicable), and payroll taxes.

Taxable Income at Exercise = Number of Shares Exercised × (Fair Market Value – Exercise Price)

Taxation After Exercise:

If the employee chooses to retain the shares upon exercise (i.e. “Exercise & Hold”), then they simply own shares of the company outright. This is analogous to holding an individual stock in a brokerage account. The value of the shares will fluctuate with the ever-changing stock price. Upon eventual sale, the sale will be subject to Capital Gains taxation.

Tax Timing Control:

This highlights a benefit of NQSO, which is the concept of tax timing control. While an employee has the ability to exercise their NQSOs immediately upon vest, a better strategy might be to defer until another calendar year. For example, an employee is projected to be in the 37% Federal Tax bracket this year, but is projected to be in to the 24% Federal Tax bracket next year. The employee may consider deferring exercise (and thus, the taxable event) until next year.

It’s important to remember, however, “there’s no free lunch”. By delaying exercise, the employee retains the single-stock risk. If the stock price declines, the employee’s desired tax savings could be more than offset by the stock decline.

NQSO awards are conditional on retained employment at the company. Upon separation of service, employees typically have 90 days to exercise any vested, but unexercised, NQSOs. Any unvested NQSOs are typically forfeited. This can make the prospect of changing jobs or retiring more complicated (and expensive) knowing dollars would be “left on the table”.

• Letting Valuable Options Expire: NQSOs have an expiration date, and even “in the money” options become worthless if you don’t exercise them in time, especially post-separation when the clock ticks faster.
• Losing Value at Departure: Leaving the company means forfeiting unvested NQSOs and typically just having 90 days to exercise vested NQSOs. Missing this window—or not understanding your vesting schedule (cliff vs. graded)—can cost you significant value.
• Misjudging Tax and Leverage Risks: Delaying exercise for tax savings can backfire if the stock drops, and leverage amplifies both gains and losses (e.g., a 10% price drop wiping out value). Additionally, do not automatically assume the mandatory tax withholding upon exercise is sufficient.
• Over-Concentration in Company Stock: Holding shares after exercise ties your wealth to a single stock’s fate. Without diversifying, a downturn can erase gains you’ve locked in.