Should a Startup Allow Early Exercise of Stock Options?

author avatar by Greg Miaskiewicz • 7 min

Startups that allow the early exercise of stock options help minimize their employees’ tax liabilities and increase the return on common stockholder equity. At Capbase, we believe there is no downside to a new company in permitting the early exercise of stock options as part of their equity purchase agreement.

Early exercise allows employees and founders to essentially purchase shares under the terms of various types of equity options packages before they are fully vested, thus translating those options into real shares that may now be allowed to mature and be taxed as long term gains when they are sold in the future.

Until they vest, however, they may not be sold, nor do they confer voting rights. There is, of course, some tax liability involved with early exercise, but if used correctly, early exercise could allow an employee to pay closer to 20% tax rather than the 50% tax they might be liable for if their options are exercised at the time of their vesting.

There are some that would argue against allowing early exercise, but these arguments are largely based on incorrectly deployed early exercise strategies. With a complete understanding of employee stock options and a cogent equity plan, if shares are properly priced, there should be no egregious tax liability at the time of exercise.

Thanks to Capbase’s cap table management and filing solutions, concerns that adding new shareholders to the cap table can cause confusion and record-keeping difficulties are no longer of concern.

The typical compensation package for a startup today should include information to educate your employees on the basics of early exercise so they can take advantage of what it has to offer and make their own informed decisions.

Restricted Stocks or ISOs?

In a later stage company, Restricted Stocks or RSUs may be awarded to founders and employees (see Employee Stock Compensation: Equity vs. Options for finer distinctions between these two), but in most early stage companies, their equity grants are made as Stock Options, which provide the right to buy company shares at a predetermined price.

In most cases, these options will either be ISOs or Restricted Stocks (sometimes called Restricted Shares), each of which will come with a vesting schedule which dictates when the holders can exercise the options and buy shares. When options vest, shares of stock may be bought at the predetermined price—known as the exercise price or the strike price.

Taxation

The stock option grant price for Qualified Incentive Stock Options (ISOs) must be equal or less than the FMV at the date of the grant, so in early stage companies, they are generally very inexpensive to exercise. If you allow your employees early exercise, they will only be liable for AMT (Alternative Minimum Tax) on the spread between the exercise price and FMV, which will in most cases be zero.

If your employees plan to early exercise their ISOs, they must file an 83b election within 30 days of the grant date to get special tax treatment. After they have been early exercised, ISOs are taxable at the long-term capital gains rate if held for more than 2 years since their date of grant and 1 year since their date of exercise.

Otherwise, ISOs will be taxed as ordinary income. In a certain year, any ISO stock issued over the amount of $100,000 will automatically become another class of stock, NSOs, which have different tax obligations. See our article on NSOs vs. ISOs for more info on the difference between the two.

Restricted Stocks are taxed in a similar way and do not need to be held more than 1 year to be eligible for long term capital gains taxes in the case of early exercise.

Consider this example of two employees at the same company, Cluster Engineering Co.:

As you can see, Cluster Engineering Co. is a rather successful company, and has received not one but two 409a valuations in the calendar year. Though both Jesse and Michael started at the company at the same time with the same 1 year vesting schedule, Jesse was allowed early exercise of his Restricted Stocks, while Michael was not.

Since Jesse early exercised, he had minimal income tax liability for 2020. As his $.005 per share price was equal to the FMV at the time, he only paid AMT tax on the price of his 10,000 share grant, $500. If we generalize to an (fairly low) AMT rate of 28%, this is about $180.

When he sold the next year, he paid the lower rate for long term gains, which we’ll assume is 20%, though it may vary. At this rate, the final value at which he sold, $2.00, means his tax burden for the year of 2021 was $3900.

So, Jesse’s total tax bill was $180 + $3900 = $4080, and his total profit, $15,920. Not bad for a year of work.

Michael, on the other hand, was not allowed to early exercise, and paid regular income tax on the price of his stock grant in 2020, which at a rate of 24% comes to about $120. When his shares vested in 2021, he sold them at the same price as Jesse. Unfortunately, he was unable to claim them as long term gains and thus forced to pay AMT on the difference between their FMV and his grant price.

At a rate of 28% AMT, Michael has a tax burden for the year of $5460, making his total tax bill $120 + $5460 = $5580, and his total profit from his stocks is $14,420.

While this may not seem like significantly less, keep in mind that as the amount of stocks awarded goes up, the discrepancy can become quite extreme. Years ago, as the first engineer hired at a growing startup, I purchased a significant number of my shares after they had already vested when I was leaving the company—my tax bill ended up being over $60k and I had to sign up for a payment plan from the IRS in order to pay down my tax liability. I wish I had known more about early exercise at the time!

TL;DR:

  • Most early stage companies prefer to issue employees equity compensation as ISOs and executives Restricted Stocks.
  • Both ISOs and Restricted Stocks are eligible for an 83(b) election which minimizes immediate tax liability.
  • In a certain calendar year, any stock granted over $100K is qualified as NSO by default.
  • You must hold ISOs at least 2 years from the date of grant to qualify for taxation as a capital gain. Restricted Stocks must only be held one year.

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author avatar

Security expert, product designer & serial entrepreneur. Sold previous startup to Integral Ad Science in 2016, where he led a fraud R&D team leading up to a $850M+ purchase by Vista in 2018.