How to Handle ISO Valuation and the $100K Limit

Pre-IPO companies and those that have recently gone public are the most prevalent granters of employee stock options. These awards create an opportunity for significant upside, particularly the incentive stock option (as defined in Section 422 of the Internal Revenue Code), which confers favorable tax treatment to the recipient.

Employees aren’t taxed on their ISOs until the day they sell them. They also benefit from lower long-term capital gains tax rates if they hold the stock for the required period of time (one year from the exercise date and two years from the grant date).

Imagine receiving options on stock that start out at $0.50, appreciate at a significant multiplier by the eventual IPO date, and leave you owing tax on that appreciation only at the long-term capital gains tax rate instead of the ordinary income rate. The issuing company is also likely unprofitable, meaning it doesn’t need the corporate tax deduction it misses out on by granting ISOs.

As pre-IPO companies mature and progress toward an eventual liquidity event, you tend to see ISO granting prevalence levels decrease for many reasons. One is a desire to capture the corporate tax deduction. Another is to reduce the administrative headaches of ISOs. A third is the view that employees will prioritize liquidity over favorable tax treatment—that is, they’ll violate the ISO rules and voluntarily give up taxation at the long-term capital gains rate.

Nonetheless, even when companies transition away from granting ISOs, they must still track and account for outstanding ISOs. 

ISO $100K Limit

In spite of their benefits, ISOs have many limiting conditions. A particularly important one being that the aggregate grant date fair market value of ISOs that become exercisable for an employee cannot exceed $100,000 in any calendar year. If the value exceeds the $100K limit, the excess amount that becomes exercisable in the calendar year loses its preferential tax benefit, effectively turning into a nonqualified stock option.

To ensure proper tax treatment and tracking, companies often split the original award into ISO and NQSO portions, which can be difficult from an administrative standpoint.

For example, on 1/1/20X1, employee A is awarded 12,000 ISOs with a grant date fair market value and a strike price of $10. The award has a monthly vesting schedule with a vest end date of 12/31/20X1. As a result, there will be a total grant date fair market value of $120,000 exercisable in 20X1, $20,000 above the $100,000 limit.

To properly track the tax treatment for this award, the company will classify $100,000 of it as ISOs and the remaining $20,000 as NQSOs. This is achieved by artificially splitting the award into two different awards that have the same grant date and strike price, but different vesting schedules.

Example: An ISO Award Split into ISO and NQSO Portions

Original Grant

Split Grant

Due to this split, the stock administration system shows that employee A received two separate awards, one with an award type of ISO and one with an award type of NQSO.

As ISO/NQSO splits are enacted, you need to also consider all ISOs that will become exercisable in the year. If there are multiple grants resulting in exercisable ISOs in a particular year, the aggregate amount must be referenced when performing the split, which could cut across multiple grants, giving rise to participant confusion.

And, since ISOs that breach the $100,000 watermark are converted to NQSOs, they’re taxed like NQSOs. Participants may be surprised if they see tax withholding on the newly created NQSOs.

Another complication is how a cancellation event, acceleration, vesting modification, or leave of absence influences the application of the $100,000 rule. Cancellations will pull exercisable shares off the table, reducing the number of shares converted to NQSOs. Accelerations are likely to do the opposite. Leaves of absence usually freeze the vesting schedule, but this will depend on the specific plan rules.

Finally, mergers and acquisitions can create their own challenges for ISOs. Many merger agreements allow for accelerations upon a change in control. In this case, when an acquisition occurs, some, or all, of the unvested options are accelerated. In practice, the acquirer generally only assumes the outstanding options. Thus, the vested and exercised options won’t be loaded into the acquirer’s administration system before the acquisition. Those vested and exercised options need to be taken into consideration when determining the $100K limit when the outstanding ISOs are accelerated. When this happens, additional steps are required to split the outstanding ISO awards correctly.

Assumed options with double-trigger provisions will add further complexity because the shares will be accelerated and become exercisable upon termination events, which potentially requires more ISOs to be converted into NQSOs.

 Valuation Considerations

For expensing purposes, stock options are generally valued using the Black-Scholes-Merton (BSM) formula. This value will differ from the value of the option for purposes for the $100,000 rule, which is simply the market value of the underlying stock on the grant date.

One of the key inputs into the BSM model is the expected term, which is an estimate of when the employee will exercise. When the option is split into ISO and NQSO, companies should be careful not to value them separately, even though they’re presented as two different awards in the stock administration system.

While the split may influence exercise behavior and exercise sequencing decisions, adequate historical data to prove this is rarely available.

In our experience reviewing ISO/NQ setups, we occasionally see different valuations between the split award types. However, we don’t find empirical support or a deliberate valuation premise for assigning different values. Instead, the system usually inadvertently applies different assumptions as a result of the differential vesting schedules.

Using the same example as earlier, the expected term for the ISO portion would theoretically be shorter than the NQSO portion since the time to vest is shorter (i.e., 10 months at the longest for the ISOs and 12 months at the longest for the NQSOs).

If companies use default tools in the reporting system to value these options, they may inadvertently apply different fair values to each portion of the option due to the differences in expected terms. However, insofar as legacy “term-from-vest” expected term estimation methods have lost their appeal, the most common practice is to apply an aggregate expected term assumption to the entire award.

For simplicity and given data limitations, the two award components are generally given the same fair value. Arriving at this outcome may require workarounds and careful modeling to avoid unintended results. 

Summary

ISO granting has immense benefits, especially at early stages in the pre-IPO lifecycle. Even if employees ultimately choose liquidity over favorable tax treatment, the message to recruits that the company grants tax-efficient stock options is powerful. Ultimately, many companies eventually navigate from ISOs to NQSOs (and then away from options altogether).

It’s crucial to understand the $100K limit and its valuation implications. Doing so ensures awards are properly tracked within the stock administration system and helps prevent unintended accounting consequences.