Stock Option / RSU Agreement — US Drafting Reference

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Drafting reference for US Stock Option and RSU agreements — ISO vs NSO, IRC § 422, § 409A, § 83(b), Rule 701, vesting, double-trigger acceleration.

The Stock Option Agreement and the Restricted Stock Unit (RSU) Agreement are the two principal equity-compensation instruments used by US corporations to grant employees, directors, consultants, and other service providers a stake in the company’s future appreciation. Each is a granular contract entered into between the corporation and a single recipient under the umbrella of an equity-compensation plan (a Stock Plan or Equity Incentive Plan) that has itself been approved by the board and stockholders. The two instruments are economically similar — both deliver equity-linked compensation conditioned on continued service — but legally and tax-wise they sit in different parts of the Internal Revenue Code and are subject to fundamentally different rules. This page is the US drafting reference for both, organised by instrument.

Two Instruments, Three Sub-Types

In contemporary practice, the corporation chooses among three sub-types:

  1. Incentive Stock Option (ISO) — a tax-favoured option under IRC § 422. Available only to employees; subject to statutory limits; favourable long-term-capital-gain tax treatment if holding periods are satisfied.

  2. Non-Qualified Stock Option (NSO) — any option not satisfying § 422 (or one that an issuer affirmatively designates as non-qualified). Available to employees, directors, consultants, and any service provider; governed by IRC § 83 generally; ordinary income on the spread at exercise.

  3. Restricted Stock Unit (RSU) — an unsecured promise of future stock delivery, conditioned on continued service and (in private companies) on a liquidity event. Governed by IRC § 83 (and § 409A for deferred settlement). Ordinary income on FMV at settlement.

The choice is driven by tax-economics, securities-law constraints, and the stage and type of the issuer. Pre-IPO start-ups typically issue ISOs to employees and NSOs to consultants and directors. Late-stage and public companies increasingly use RSUs because they avoid the exercise-price-funding problem and provide more predictable tax timing.

Incentive Stock Options (ISOs) — IRC § 422

ISOs are tax-favoured: no ordinary income at grant, no ordinary income at exercise (subject to the AMT preference below), and — if holding periods are satisfied — long-term capital gain on the entire spread between exercise price and sale price. The cost is a thicket of statutory requirements.

ISO qualifying requirements (IRC § 422(b)):

  • Granted only to employees of the issuer or a parent/subsidiary. Consultants and non-employee directors cannot receive ISOs.
  • Issued under a written plan approved by stockholders within twelve months before or after board adoption.
  • Granted within ten years after plan adoption or stockholder approval (whichever is earlier).
  • Maximum ten-year exercise term. (Five-year term for ISO holders who own more than 10% of the issuer’s voting stock — the so-called “10% shareholder” ISOs, which also require exercise price ≥ 110% of FMV at grant.)
  • Exercise price not less than fair-market value at grant. Below-FMV options are NSOs by operation of law.
  • $100,000 annual vesting cap. ISOs that vest in any one calendar year with aggregate FMV (at grant) exceeding $100,000 are treated as NSOs to the extent of the excess. The cap is per holder, per issuer; ordering rule applies to determine which options spill over.
  • Non-transferable — except by will or inheritance.
  • Exercise within three months of termination of employment for ISO status; longer for disability (one year) or death (typically through the option’s stated term).

ISO tax treatment (IRC § 421 and § 422):

  • Grant. No tax.
  • Exercise. No regular income tax. But the spread (FMV at exercise minus exercise price) is an AMT preference item under IRC § 56(b)(3) — meaning AMT-system tax may be owed even though no regular tax is owed. This is the principal tax trap for ISO exercisers.
  • Sale, holding periods met. Long-term capital gain on (sale price minus exercise price). Holding periods: at least two years from grant date and at least one year from exercise date. Both periods must be satisfied (the “two-year-from-grant, one-year-from-exercise” rule).
  • Sale, holding periods not met (a “disqualifying disposition”). The spread at exercise (or, if lower, at sale) is ordinary income; any further appreciation is short- or long-term capital gain depending on the holding period from exercise.

Form 3921 (26 CFR § 1.6039-1) — required ISO-exercise reporting; employer issues to employee and IRS by January 31 of the year following exercise.

Non-Qualified Stock Options (NSOs) — IRC § 83

NSOs are the work-horse of equity compensation: simpler tax treatment, broader recipient pool, no statutory caps.

Tax treatment:

  • Grant. No tax (assuming option is granted at FMV and is not transferable other than by will or inheritance — the so-called “no readily ascertainable fair market value” safe harbour of Treas. Reg. § 1.83-7).
  • Exercise. Ordinary income on the spread (FMV at exercise minus exercise price). Employer must withhold income tax, FICA, Medicare; reports on W-2 (employee) or 1099-NEC (contractor).
  • Sale. Capital gain (or loss) on (sale price minus FMV at exercise). Long- or short-term depending on holding period from exercise.

NSOs are available to any service provider: employees, directors, consultants, advisors. The exercise price is typically the FMV at grant (per § 409A — see below), but NSOs are not statutorily required to be at-FMV (a below-FMV NSO is not invalid; it is just an immediate ordinary-income event under § 409A and § 83).

IRC § 409A — Non-Qualified Deferred Compensation

The most consequential post-2004 development in equity compensation is IRC § 409A and its accompanying regulations. § 409A applies to non-qualified deferred compensation arrangements; a stock option granted below FMV at grant is treated as deferred compensation. Failure to comply with § 409A results in immediate inclusion of the vested value in income plus a 20% additional federal tax plus interest.

The § 409A regulations provide safe harbours for determining FMV in private companies:

  • Independent appraisal valuation. A valuation by a qualified independent appraiser, performed within twelve months prior to the grant, creates a presumption of reasonableness (rebuttable only by IRS showing of “grossly unreasonable”). This is the standard private-company practice.
  • Illiquid start-up safe harbour. For companies less than ten years old, with no readily-tradable stock, written reasonable application of a reasonable valuation methodology.
  • Formula method. Pre-established formula (e.g., book value) applied consistently — narrow utility.

The practical regime: pre-IPO companies obtain a “409A valuation” every twelve months (or more frequently on material events: financings, M&A activity, significant operating change). All ISO and NSO grants in the intervening period use the most-recent 409A as the exercise price. Failure to maintain the 12-month cycle voids the safe harbour and exposes optionees to immediate § 409A taxation.

IRC § 83(b) Election — Restricted Stock (Not Options)

A frequent source of confusion: the § 83(b) election applies to restricted stock (and to early-exercised stock options where the resulting stock is restricted), not to unvested stock options themselves.

The election (IRC § 83(b)): a service provider who receives restricted stock can elect within thirty days of transfer to include the FMV-at-grant (minus purchase price) in ordinary income immediately, fixing the cost basis. Subsequent appreciation is capital gain. Without the election, the service provider is taxed at vesting on the FMV-at-vesting (minus purchase price) — which can be dramatically higher.

The election form is one page; it is filed with the IRS by mail within thirty days (a strict statutory deadline — no extensions, no equitable tolling). Late filings are universally rejected.

The early-exercise strategy. A common strategy for highly-valued start-up grants: the company allows the option to be exercised before vesting (with the resulting stock subject to repurchase at cost on termination), and the optionee timely files a § 83(b) election. If the exercise occurs at low FMV, the § 83(b) inclusion is zero or minimal; subsequent appreciation is all capital gain on sale. The risk: the optionee pays the exercise price up-front for stock that may never vest. This strategy is invitation-only — not every plan permits early exercise, and not every optionee should take it.

Vesting Schedules

The Silicon Valley standard since the early 1980s is:

  • 4-year total vesting period
  • 1-year cliff — none of the grant vests until the 1-year anniversary; on that date, 25% vests
  • 36 monthly tranches — the remaining 75% vests in 36 equal monthly instalments

This is the FAANG/start-up baseline. Variations:

  • 3-year vesting (more common at late-stage start-ups; common for refresh grants)
  • Quarterly vesting (vs. monthly) — investor-favourable, slightly more discrete impact on retention
  • Performance vesting — vests on achievement of specified milestones (revenue, market share, product launch). Common for executives.
  • Time-plus-performance hybrid — both must be satisfied.

Acceleration on M&A

Acceleration rules govern what happens to unvested options on a Sale of the Company. Two principal patterns:

Single-trigger acceleration. All (or some specified portion) of unvested options accelerate on the closing of a change-of-control transaction. Employee-favourable.

Double-trigger acceleration. Acceleration requires both (a) a change-of-control transaction and (b) the optionee’s termination without cause (or resignation for good reason) within a specified period after closing (typically 12 months). Investor-favourable and more common at venture-backed companies.

Some plans use hybrid acceleration: a partial single-trigger (e.g., 50% on M&A) plus the balance on double-trigger.

The board’s discretion to assume, substitute, cash out, or terminate options in the M&A transaction is typically reserved in the plan. The Stock Option Agreement should reference and incorporate the plan’s M&A provisions.

Termination of Service

NSO standard post-termination exercise period. Ninety days post-termination of service is the contemporary default. Some plans extend to three years or longer to mitigate the well-known problem of “leaver lockout” — where the optionee leaves a private company, lacks liquidity to fund the exercise, and is forced to abandon vested options. The trade-off: longer post-termination periods extend the optionee’s exposure to plan-administration tracking and (under longer-than-three-month rules) convert ISOs to NSOs as a § 422 matter.

ISO post-termination period. Three months post-termination is the ISO statutory ceiling under § 422(a)(2). Exercise after that window converts the option to NSO treatment (with the corresponding ordinary-income consequences on the spread at exercise). For disability, the period extends to one year; for death, typically through the option’s stated term.

Termination for cause. Most plans extinguish unvested and vested options on termination for cause — a significant departure from the general rule that vested options survive termination. Cause definitions are heavily negotiated for executive grants.

Retirement. Where the optionee qualifies as a “retiree” under the plan, vesting may accelerate and the post-termination exercise period may extend. Definition of retiree (age, years of service) is plan-specific.

Restricted Stock Units (RSUs)

An RSU is an unfunded promise to deliver stock (or cash equivalent at the issuer’s election) at a specified future event — typically vesting, possibly later. Unlike options:

  • No exercise price — the optionee receives stock outright on vesting.
  • No election event by the optionee at grant — § 83(b) is unavailable for RSUs (because no property transfer at grant).
  • Tax timing: ordinary income on FMV at settlement (delivery of the underlying stock). FICA/Medicare due at vesting; income tax due at settlement (which may differ from vesting).

Public-company RSUs. Time-based vesting (e.g., 4-year monthly with 1-year cliff); settlement on or shortly after vesting. The employee owes ordinary income at vesting on the FMV; the employer withholds tax (often by sell-to-cover — selling enough shares at vesting to fund the withholding).

Private-company RSUs — double-trigger. Private-company RSUs almost universally use a double-trigger vesting structure to avoid the “tax-without-liquidity” trap: an RSU vests on (a) satisfaction of a time-based service condition and (b) a liquidity event (M&A or IPO). Without the liquidity-event trigger, the employee would owe ordinary income at time-vesting on illiquid stock — with no market to sell into to fund the tax. The double-trigger structure defers the income event until the stock is liquid.

The downside of double-trigger RSUs is that they expire if no liquidity event occurs within the maximum permissible deferral period (typically 7-10 years from grant). Plans usually specify what happens if the time-condition is satisfied but the liquidity-condition is not by the maximum date — the RSU is generally forfeited.

Section 409A and RSUs. RSUs are deferred compensation under § 409A unless the settlement date is sufficiently linked to the vesting event. The “short-term deferral exception” (settlement within 2.5 months after the end of the year in which the substantial risk of forfeiture lapses) is the standard structure for time-vested public-company RSUs. Private-company double-trigger RSUs must be carefully structured to fall within § 409A’s permissible payment events (separation from service, death, disability, change in control, fixed schedule, unforeseeable emergency).

Section 16 Reporting (Officers and Directors)

Section 16 of the Exchange Act and its rules require officers, directors, and 10% beneficial owners of public-company stock to report changes in beneficial ownership on Form 4 within two business days of the transaction. Stock option grants and RSU grants to Section 16 insiders trigger Form 4 filings. The Stock Option Agreement and RSU Agreement should reference the reporting obligation and the plan’s procedures for facilitating timely reporting.

Securities Law — Rule 701 and Form 144

A grant of stock options or RSUs by a private company is an offer and sale of securities under Section 5 of the Securities Act of 1933 — unless an exemption applies. The principal exemption for private-company employee equity is Rule 701:

  • Available to non-reporting (private) companies.
  • Securities issued pursuant to a written compensatory plan to employees, directors, consultants, and certain advisors.
  • Annual aggregate sales price cap: greater of $1M or 15% of total assets or 15% of outstanding stock.
  • Above $10M in any 12-month period: enhanced disclosure obligations (financial statements, plan summary, risk factors) to recipients within a specified window before sale.

On exit (IPO), the issuer must comply with Rule 144 for resale of restricted securities. Rule 144 holding periods: six months for reporting issuers, twelve months for non-reporting issuers. Affiliate-of-the-issuer status (officers, directors, 10% holders) layers additional volume and manner-of-sale limitations.

Form 3921 and Form 3922

  • Form 3921 — issuer reports ISO exercises. Due to employee and IRS by January 31 of the year following exercise.
  • Form 3922 — issuer reports first-transfer-of-stock from ESPP qualifying purchases. Due similarly.

These forms are part of the IRS information-reporting regime for compensatory equity; failure to file is sanctionable.

Sample Stock Option Agreement Structure

  1. Grant of Option (number of shares, type — ISO or NSO, exercise price, grant date, vesting commencement date)
  2. Plan Incorporation (the umbrella stock plan)
  3. Vesting Schedule (and acceleration provisions)
  4. Exercise Mechanics (cash, cashless / net exercise, stock-for-stock)
  5. Tax Treatment (ISO vs. NSO; § 409A; 83(b) availability for early exercise)
  6. Termination of Service
  7. Transferability (none, except by will or inheritance)
  8. Lock-Up (pre-commitment to IPO underwriter lock-up)
  9. Securities Laws (Rule 701, Rule 144, restrictive legend)
  10. Right of First Refusal / Repurchase Right (private-company-specific)
  11. General Provisions (Notices, Amendment, Integration, Severability, Governing Law)

Sample RSU Agreement Structure

  1. Grant of RSUs (number of units, grant date, vesting commencement date)
  2. Plan Incorporation
  3. Vesting Schedule (service-based; liquidity-event trigger for private companies)
  4. Settlement (timing, form — stock or cash, sell-to-cover authorisation)
  5. Tax Withholding (FICA/Medicare at vesting; income tax at settlement)
  6. § 409A Compliance Provisions
  7. Termination of Service
  8. Transferability (none)
  9. Lock-Up
  10. Securities Laws (Rule 701, Rule 144)
  11. General Provisions

Bibliography

Cross-references

Further Reading

Disclaimer: This content is informational, not legal advice. Last verified: 2026-05-10. Always consult licensed counsel for binding decisions.