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Incentive Stock Options (ISOs) – what’s the deal?

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Increasingly, businesses are looking to find ways to reward staff for their hard work, above and beyond their salaries. Companies are competing for the best talent, so there’s got to be a sweetener to attract – and retain – key players.

Perks such as medical benefits, paid vacation and gym membership are becoming the norm and discerning employees are looking for something more that will really keep them engaged.

Equity compensation allows employees to become shareholders in a company and therefore share in its profit and growth.

By aligning their own finances to the company’s growth, staff become much more clued into its targets, goals and growth.  Incentive Stock Options (ISOs) are a hugely popular choice of equity compensation.

 

What are ISOs?

ISOs are qualified options and come with added tax benefits to employees. When an employee exercises an ISO, it’s possible to treat any gain or profit as taxable at the capital gains rate, rather than at the standard income tax rates. This means that employees will end up with more of the profits in their own pocket.

The tax benefits only come into play, however, when the correct terms regarding grant dates and exercising are met. For example, the sale of the ISO must be made at least two years after the grant date and one year after it was exercised for it to qualify. Disqualified disposition is when the sale of ISOs takes place without having met the outlined holding period requirements.

ISOs are normally given a market value price by the company on the grant date. There is normally a set period of time that an employee has to wait for the options before vesting and before they exercise. This is so that when the market value of the stocks increase over time, the employee can then purchase the stock at a discount and then sell them at a premium and for-profit when the time comes.

 

How do ISOs work?

ISOs are issued on the grant date and employees purchase the options by the exercise date. Once they’re exercised, employees can choose to sell off the stock immediately or wait for a while if they think it’s likely that the stock will rise further.

The offering period for ISOs is set by the company and after this, the option expires. ISOs have a vesting schedule that they have to adhere to before they can be exercised. There are usually two types of vesting schedules – the standard, which is a one to three-year cliff schedule, and a graded vesting schedule. A graded vesting schedule is when an employee’s stocks are invested incrementally every year, with them being completely vested in all their options by the fifth year.

 

How to exercise ISOs

There are various ways in which ISOs can be exercised. Employees can pay for the stock in cash, by stock swap transaction or by a cashless transaction. Stocks can normally be exercised at a lower price than the current market value of the stock and because of this, ISOs allow employees to make an immediate profit upon exercising. In the case of qualifying transactions, the employee would be liable for long-term or short-term capital gains tax on the sale. With disqualifying ISOs, employees would have to pay regular income tax.

 

Who normally gets ISOs?

ISOs are normally part of stock plans limited to key employees and senior management or executives of a company. They behave as ‘golden handcuffs’ to keep key staff on board. ISOs are especially important when a business is in start-up mode as oftentimes, companies that are in the early stages of growth are competing with established firms for staff.

They may not have a level playing field when it comes to the salaries they offer, but they may attract experienced, senior-level experts by offering ISOs on top of their salary package.

 

Can ISOs be clawed back?

There are terms and conditions that apply to all employee stock plans that participants need to be aware of. There are provisions within plans in which employees can recall ISOs under predetermined circumstances. For example, clawing back shares may happen if a person leaves the company for any reason other than death, retirement, disability. There may also be a clause that states that ISOs will not be honoured in instances where the company has become so financially unstable that it is no longer in a position to pay out and fulfil its obligations as set out in the plan.

Read more here about Employee stock options and how we can help.

 
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ISOs are just some of the Long Term Incentive Plans (LTIPS) that Global Shares manage for companies all over the world. Request a free demo to find out more about our other products and services.

Please Note: This publication contains general information only and Global Shares is not, through this article, issuing any advice, be it legal, financial, tax-related, business-related, professional or other. The Global Shares Academy is not a substitute for professional advice and should not be used as such. Global Shares does not assume any liability for reliance on the information provided herein.

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