Incentive Stock Option Agreements: What Founders and Employees Need to Know

As startups grow and begin formalizing compensation plans, Incentive Stock Options (ISOs) are one of the most tax-advantaged ways to grant equity to employees. Governed by Section 422 of the Internal Revenue Code, ISOs offer favorable tax treatment compared to non-qualified stock options—but they come with specific rules, qualifications, and potential pitfalls that both companies and employees need to understand.

What Is an Incentive Stock Option (ISO)?

An Incentive Stock Option Agreement is a legal document that outlines the terms under which an employee can purchase company shares at a fixed price (the exercise price) in the future. ISOs are only available to employees (not advisors or contractors) and are intended to qualify for capital gains tax treatment if certain holding requirements are met.

Key Terms in an ISO Agreement

• Exercise Price: Set at or above fair market value (FMV) at the time of grant
• Vesting Schedule: Typically 4 years with a 1-year cliff
• Exercise Window: 90 days after termination (can be longer for non-ISOs)
• Tax Treatment: No ordinary income tax at grant or exercise if holding period is met
• 409A Valuation: Required to establish FMV and avoid tax penalties
• ISO $100K Rule: Only $100K worth of ISOs (based on FMV at grant) can become exercisable per year
• Disposition Rules: Shares must be held for 2 years from grant and 1 year from exercise for ISO treatment
• Eligibility: Must be a W-2 employee

Benefits and Limitations of ISOs

Advantages:

• Tax-efficient: No income tax on grant or exercise if holding periods are met
• Long-term capital gains potential on sale
• Viewed favorably by employees and early-stage hires

Limitations:

• May trigger Alternative Minimum Tax (AMT) upon exercise
• Only available to employees, not advisors or contractors
• Must be exercised within 90 days of leaving the company

ISO vs NSO (Non-Qualified Stock Option)

ISO:

• Eligible only for employees
• No regular income tax at exercise (but AMT may apply)
• Capital gains if holding periods are met
• Must be exercised within 90 days of leaving
• Governed by IRS Section 422

NSO:

• Available to employees, advisors, and contractors
• Taxed as ordinary income at exercise
• Capital gains apply only on appreciation post-exercise
• May have a longer post-termination exercise window (up to 10 years)
• Governed by IRS Section 83

Best Practices for Founders and Employees

• Get a 409A valuation before issuing ISOs
• Educate employees on vesting, taxation, and deadlines
• Offer early exercise to allow capital gains clock to start sooner
• Use a cap table platform like Carta or Pulley to manage grants
• Model the AMT impact if planning to exercise early

Closing Thoughts

The Incentive Stock Option Agreement is a cornerstone of startup equity compensation—but its benefits come with complexity. Founders must ensure compliance, while employees need education to take full advantage of ISOs’ tax efficiency and upside potential.