Employee stock options: ISOs, NSOs and RSUs
ISOs, NSOs and RSUs: how each is taxed, Northwind's first grants to Priya Shah and Marcus Lee, and the expense they put on the P&L.
On October 1, 2026 Northwind's board reserves an option pool of 1,000,000 shares under an equity incentive plan the stockholders approve. On December 1, 2026 it grants 40,000 options to Priya Shah, its operations manager, and 25,000 to Marcus Lee, its warehouse associate — incentive stock options at an exercise price of $0.06, the 409A value, vesting over four years with a one-year cliff.
An option is the right to buy a share at a fixed price later. Its value to the employee is the gap between that price and what the share becomes worth.
In this lesson: the 409A valuation and the strike price, the $100,000 ISO limit and early exercise, the 90-day exercise window, and RSUs.
Pages in this lesson
4 pages go deeper, about 17 minutes in all. Read them in order, or open the one you need.
- The 409A valuation and the strike priceWhat is a 409A valuation and why does it set the strike price?
- The $100,000 ISO limit and early exerciseWhat is the $100,000 ISO limit, and how does early exercise affect it?
- The 90-day exercise windowWhat happens to stock options when an employee leaves?
- RSUsWhat is an RSU, and when do companies switch from options to RSUs?
Where this lesson's rules come from
The sources behind this lesson's requirements, by kind. Background reading explains; it is never the authority for a rule. Anything marked as a convention is ours, not the rule-maker's.
- Federal statute
- 26 U.S.C. §422(b)(4) (opens in a new tab)Incentive stock options: priced at fair market value, ten-year term, employees onlyFree to read
- IRS guidance
- IRS Topic No. 427, Stock options (opens in a new tab)ISOs at grant and exercise, NSOs at exercise, and the AMTFree to read
- IRS Pub. 525 (2025), Statutory Stock Options — Form 3921 (opens in a new tab)Form 3921 to every employee who exercised an ISO in 2025Free to read
- US GAAP
- ASC 718 — Compensation—Stock Compensation (opens in a new tab)Equity awards are an expense, measured at grant-date fair value — and move no cashFree after registration
- Background reading — not an authority
- Wikipedia, “Incentive stock option” (opens in a new tab)Incentive stock options — backgroundFree to read
The full map is in US GAAP, and where these rules come from.
The words this lesson teaches
Each links to its glossary definition, which also names the authority behind it and the components that render it.
- Incentive stock optionA stock option meeting IRC §422: employees only, granted under a stockholder-approved plan, strike at least fair market value, exercisable for no more than ten years. No regular tax at grant or exercise (the spread can trigger AMT); gain is capital if the stock is held two years from grant and one from exercise. Only $100,000 of stock, valued at grant, may first become exercisable in a calendar year
- Nonstatutory stock optionA stock option that is not an ISO — any grant to a contractor or director, and an ISO's excess over the $100,000 limit. With no readily determinable value at grant, the spread is ordinary income at exercise, as wages for an employee
- Exercise priceWhat an option holder pays per share to buy it. Set at least at fair market value on the grant date — the 409A value for a private company — to keep an option outside §409A and, for an ISO, inside §422
- Option poolShares the board reserves under a stockholder-approved equity plan for future grants of options and other awards. Granted options and the unissued remainder both count in fully diluted shares
- 409A valuationAn appraisal of a private company's common stock at fair market value, so options granted with a strike at or above it avoid the tax penalties of IRC §409A. A tax safe harbor; the books measure option expense under ASC 718, often starting from the same common-stock value
- Stock-based compensationThe cost of equity awards — options, RSUs, restricted stock — measured at grant-date fair value and recognized as expense over the service period. Non-cash, so added back in operating cash flow, but a real cost
In the founder glossary
This lesson’s ideas, explained for the founder running the company. Each has an entry in the founder glossary.
See also
- Journal entry for stock-based compensationEach month of the service period, debit Stock-based compensation expense and credit Additional paid-in capital for the grant-date fair value of the awards divided over the vesting period. No cash moves and no liability is created for equity-classified awards.
- Stock options, 409A valuations and vesting for startupsHow option strike prices are set by a 409A valuation, how vesting and the cliff work, and why ASC 718 makes every grant an expense on your P&L.