Non-Qualified Stock Option Agreements: What They Are and How They Work

A non-qualified stock option (NSO) agreement is a form of equity-based compensation that allows employees to purchase company stock at a predetermined price. Unlike their qualified counterparts, NSOs do not qualify for special tax treatment under the Internal Revenue Code (IRC). Although NSOs present certain risks and complexities, many companies use them to incentivize and retain employees.

How do Non-Qualified Stock Option Agreements Work?

When a company decides to offer NSOs to its employees, it typically creates a plan document and a grant agreement outlining the terms of the option. The plan document lays out the eligibility criteria, the method for determining the option price, and the vesting schedule (i.e., the period during which the option can be exercised). The grant agreement specifies the number of shares subject to the option, the exercise price, and any restrictions or conditions that apply.

Once an employee receives an option grant, they have the right to purchase a certain number of shares at the predetermined exercise price within a specified period of time. Typically, the exercise price is set at the fair market value of the stock on the grant date, although some NSOs have a discount or premium built in. The employee is not obligated to exercise the option, but if they do, they must pay the exercise price (in cash or by surrendering other shares) and receive the shares.

What are the Benefits and Risks of Non-Qualified Stock Option Agreements?

One of the benefits of NSOs is that they allow companies to offer employees a stake in the company`s success without diluting the existing shareholders` ownership. NSOs also provide employees with a potential financial incentive to work harder and stay with the company.

However, NSOs have several risks and complexities that companies and employees should consider. For example, because NSOs are not considered qualified under the IRC, the employee must pay income tax on the difference between the fair market value of the shares at exercise and the exercise price. Additionally, if the employee sells the shares, they may owe capital gains tax on any appreciation since exercise.

Another risk is that NSOs are subject to forfeiture if the employee leaves the company before the option vests or if the company undergoes a change in control. NSOs may also have restrictions on transferability, limiting the employee`s ability to monetize the option.


Non-qualified stock option agreements can be an effective way for companies to incentivize and retain employees, but they present certain risks and complexities that require careful consideration. If you are a company that offers NSOs, it is important to have a comprehensive plan document and grant agreement in place. If you are an employee considering an NSO offer, make sure you understand the tax implications and potential risks before accepting the grant.