ISOs are popular among publicly-traded companies and private firms planning a future IPO. Many find ISOs convenient because they help attract talent and incentivize employees while preserving cash. Since the cost of ISOs are not deductible for companies, they're often the preferred choice for high-growth startups that do not yet have taxable income.
ISOs are usually granted at a strike price equal to fair market value as of the grant date. In time, as the company grows and reaches important milestones, the hope is that the fair market will rise above the strike price. Then when the ISOs vest, employees could be in a position to exercise ISOs and buy shares at a significant discount to fair market value.
ISOs are almost always provided to employees subject to a vesting schedule. One of the more common vesting schedule is four years with a "one year cliff". Under this arrangement ISOs cannot be exercised until the first anniversary of the employee's start date, at which point 25% of the ISOs vest in one fell swoop.
There are two primary ways to exercise ISOs:
- Pay Cash. You could simply pay cash to buy stock at the grant price.
- Cashless Exercise. If you lack the necessary funds, you could opt for a cashless exercise by enlisting the help of a broker to receive a short-term loan. Proceeds from the loan are used to buy shares at the exercise price. All the shares or a portion thereof are then immediately sold to pay back the loan and cover commissions and withholding taxes. A cashless exercise is usually available for publicly traded shares, but this is rarely the case for shares in private companies