What Are NSOs? Your Guide to Non-Qualified Stock Options

Startup equity can be one of the most powerful tools for building wealth. But that only happens if you know how to use it. And for thousands of startup employees, the equity they’ve been granted isn’t stock outright—it’s stock options, specifically, NSOs.

Here we’ll break down how NSOs work, how they’re taxed, and what to watch for so you can make smarter moves with your equity.

What is an NSO?

NSO stands for non-qualified stock option. It’s one of the most common forms of equity compensation startups issue, and it gives you the right to buy shares of your company at a fixed price (called the "strike price") at some time in the future.

Unlike ISOs (incentive stock options), NSOs don’t qualify for special tax treatment. That means they’re taxed as ordinary income plus normal payroll taxes (Social Security & Medicare) at exercise, and not all gains can be deferred or converted into long-term capital gains.

So why do companies offer NSOs? Two reasons:

1. They can issue them to anyone. NSOs aren’t limited to employees. Contractors, advisors, and board members can all receive NSOs.
2. They’re flexible. ISOs are the most tax favorable but there is a $100K annual limit. Companies issue NSOs once they hit that annual limit for ISOs

How NSOs work: From grant to sale

Let’s walk through the NSO lifecycle:

1. Grant: Your company gives you the option to buy X number of shares at a fixed price (your strike price). This doesn’t mean you own stock yet, just that you have the option to buy it later.
2. Vest: Your options vest over time. A typical schedule might be four years with a one-year cliff.
3. Exercise: Once vested, you can "exercise" your options by buying shares at the strike price. This is when tax obligations kick in (more on that next).
4. Sell: After you own the shares, you can sell them if there’s a buyer and your company allows it (e.g., after an IPO, tender offer, or secondary market sale).

How are NSOs taxed?

Here’s where NSOs get tricky, and where planning ahead can save you thousands.

When you exercise

When you buy your options (i.e., exercise), the IRS considers the spread between the strike price and the current fair market value (FMV) to be ordinary income.

Let’s say:

• Your strike price = $1/share
• The FMV at time of exercise = $5/share
• You exercise 1,000 shares

You’ll owe income tax on $4,000 (that’s the $4 spread x 1,000 shares).

If you’re an employee, your company will typically withhold payroll taxes (Social Security, Medicare, and FUTA). If you’re a contractor, you’ll likely owe that directly to the IRS.

When you sell

If you sell the shares after exercising, you may owe capital gains tax on any increase in value since the exercise.

• Sold within one year: You pay short-term capital gains (taxed like income)
• Held > 1 year: You pay long-term capital gains (usually 0%, 15%, or 20%, depending on income)

And if you’re a high-income earner (>$200K single or $250K married), you’ll likely owe an additional 3.8% Net Investment Income Tax (NIIT). You pay NIIT on whichever is smaller—your net investment income or how much your income exceeds the threshold.

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Curious what your options could be worth? Run the numbers in 60 seconds with our free Equity Calculator.

When can you exercise NSOs?

Your NSOs will typically vest over time—say, 25% after one year, then monthly for the next three years.

You can exercise once vested. That means:

• While employed: You pay the strike price and (possibly) the taxes.
• After leaving: You usually have a 90-day post-termination window to exercise. Miss that, and your options expire.

Some companies allow for cashless exercise (selling shares to cover the cost of exercising). Others don’t. Some extend your post-termination window. Others don’t.

NSOs vs ISOs vs RSUs: A quick comparison

Unsure which alphabet-soup grant you have? Upload your offer letter, and Prospect decodes it in minutes.

What about QSBS?

Some NSOs convert into stock that qualifies for Qualified Small Business Stock (QSBS) treatment. If your company is eligible (less than $50 million in gross assets) and you hold your shares for at least five years after exercising, you could exclude up to $10M (or 10x your cost basis) in gains from federal taxes.

The catch? You need to exercise first. The five-year clock doesn’t start until you own the stock. 

Make your equity work for you

Most people find out about NSO taxes the hard way—by getting hit with a surprise bill.

That’s where Prospect comes in. We’re the command center for startup employees with equity. Whether you’re at Anduril, Ramp, or an early-stage rocketship, we’ll help you:

• Track vesting and post-termination deadlines
• Model tax costs for different exercise strategies
• Understand your QSBS eligibility
• Time your sale to maximize gains

And we don’t just answer these questions once. Our predictive models keep updating as your company grows, your stock vests, and your plans evolve.

You earned your equity. Let Prospect help you turn it into real wealth.

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