ISOs vs. NQOs

At start-up time, common stock options are valued at a relatively low price and so not a lot of money is tied up. The ISO tax advantages are significant, but don't forget that tax rates go up next year,

On the other hand, once a company is public the stock option prices are usually such that they represent a significant amount and a thus a significant risk.

I find ISOs are a dangerous thing for employees. They hear about the "great tax advantages" from someone or the internet and they just dive in and exercise early. Most of the time (just given the statistics) early-stage companies do not have an exit that takes advantage of the early exercise tax benefit (starting the clock sooner on LT cap gains) and thus the employees, who can typically ill afford to gamlbe on stock, find themselves staring at a write-off. I am not a big fan of taking options (no pun intended) off the table for employees, but I would think hard about offering them out.

Of course having tricks up your sleeve can be useful at surprising times, so you might want your counsel to allow ISOs, but simply not use them unless there is a truly compelling reason to do so.

Mark, I don't quite get Conrad's or Michael's comments -- stock options are a necessary / critical offering to employees of startups or private companies expected to be acquired or eventually go public. A MUST-DO.

So, your questions were - 1) ISOs, NQOs, or both? and 2) What to do about employees and early exercises

Question #1: TRENDS ARE AWAY FROM ISOs to NQOs
Radford and Cooley Godward published a report in the past 2 years that indicated that many VC-backed startups were moving away from ISOs to NQOs -- why? 1) Broader adaptability of NQOs(employees and consultants/3rd parties can be issued NQOs vs ISOs); 2) To reflect the reality that companies want to discourage exercise especially if employees terminate, but still hold the shares - the VCs would rather have the shares return to the pool for reissuance to current/future employees. To me, they're cleaner, simpler, and from a practical standpoint keep tracking generally to current employees/consultants.

TAX IMPLICATIONS
To be clear the tax advantages of ISOs are that there is no taxable event to the employee until they are sold. NQOs on the other hand have a taxable event to the employee when they are exercised, which can be very onerous. Regardless, I NEVER encourage employees to exercise their ISOs or NQOs until we're in line of sight to a liquidity event. Even if an IPO is imminent, the holding period for most employees is at least 180 days, if not longer, and so there's no rush for them to exercise and hold for Capital Gains treatment, because with no less than six months to prepare for IPO then the six month holding period, there should be no quetsion that any sale will be treated as Capital Gain. And the exercise price was locked in anyway. The only caveats to this are the $100K limit, the 83b election issue, and encouraging exercise when the FMV (409A validated) and thus the tax (to the employee exercising) would put any taxable gain at a bare minimum.

Keith

Keith's comments are right on the mark. ISOs are useful instruments, if only because employees expect them. If, as you mention, folks really do want to early exercise their options, NSOs can be early exercised just the same as ISOs, so ISOs do not offer any additional benefit in an early exercise situation.

Professionally, I prefer (and recommend) NSOs and it generally is just a matter of properly educating the employee base about the differences for them to understand the real differences between ISOs and NSOs. As a CEP, when I am asked the ISO v NSO question, the first big hidden issue that comes to mind are the AMT consequences of ISOs. So many folks got slammed with huge AMT tax liability for exercising their ISOs during the dot com boom and had no money to pay because the stock prices had tanked by the time they found out about the tax liability (sometimes only months later). And even though equity compensation professionals and entrepreneur blogs posted extensively on this, regular employees don't really understand what happened and why and continue exercising their ISOs oblivious to the potential consequences.

In short, it's important for employees to understand these points about ISOs:
1. Even though there is no payroll tax on the ordinary income that is the gain at the time of ISO exercise (the difference between the purchase price and the current market price on the date of exercise), that same gain can push you into an income bracket that requires a separate calculation of the Alternative Minimum Tax (AMT) AND YOU MAY HAVE TO PAY TAXES ON THE GAIN ANYWAY.
2. The only way to avoid this is by selling the ISOs before the end of the calendar year in which they were purchased. This is called a disqualifying disposition and changes the treatment of the gain to the same as an NSO - the gain will be treated as ordinary income and you will have to pay taxes. The difference is that you will pay the tax at the time you file your income tax return and not at the time of the exercise. The other important difference is that the tax will be calculated in the standard way, not the AMT way, and that's important because when calculating tax liabilty for AMT purposes many normal itemized deductions are not allowed for the purpose of reducing your taxable income.
3. By the time you take all your documents to your tax advisor to prepare your annual return it is too late because you have missed the end of the calendar year and any disqualifying disposition will not affect the ISO status of the exercised stock at the end of the tax year. This is the worst scenario because a large gain on an ISO exercise could, in this situation, have the potential to trigger AMT liability for the preceding year's taxes and then when you have to sell the stock in the following year to pay for the AMT taxes it will be a disqualifying disposition so you then lose the tax benefit of the original ISO exercise and you'll have to pay taxes on the gain at sale as if it were ordinary income instead of short term capital gain.
4. In private companies there is the additional danger that there is no market for selling the shares in order to trigger a disqualifying disposition that might save an employee from AMT tax liability. This is also true of an employee holding ISO stock during an IPO lockup period that spans two tax years (go back and read the nightmare scenaroi in item #4).
5. If you are going to exercise an ISO that has a potentially large gain, consult with your tax advisor first.

So, as you can see, there is a lot of hidden danger in ISOs that, once openly discussed, puts the ISO/NSO debate in a very different light.

I fully agree with the commentary above, and believe NQOs are the way to go today. Employees generally understand NQOs better, the ISO benefits are (as noted) more often than not unrealized, and the logistical/maintenance burden to the company for ISOs is significant.