You just joined this hot new startup that uses AI to create a snack menu for puppies based on trends in their tail movement. You believe this company is going to be big and you can’t wait for your options to vest so you can early exercise them and become a shareholder.
Good news! There’s a chance you don’t have to wait at all.
Many startup employees believe they must wait for their stock options to vest before they can exercise them. That makes perfect sense, right? How could they exercise their options if they don’t even legally own them yet? Well, things don’t always work the way we’d expect them to.
Enter EARLY EXERCISE!
If you need a refresher on stock options basics, vesting, and option-exercise, you can get that covered in our Beginner’s Guide to Stock Options.
What Is An Early Exercise?
An early exercise allows employees (option grantees) to exercise their options before they vest and as soon as they are granted to them by their employer (the issuer). That means that employees can exercise their options almost immediately after starting a new job without having to wait for their much anticipated one-year anniversary (aka “Cliff”).
If an employee that used an early exercise leaves the company before 100% of the options vest, she will get the money for the unvested portion of the options upon termination back. For example, if an employee used an early exercise provision and left the company after two years, she will get half of the exercise cost back upon her departure (assuming a typical four-year vesting schedule).
Can anybody early exercise?
No. An early exercise provision can be used only if your employer offers it. If your company offers an early exercise option, its stock option plan, which should be provided to you along with a job offer or when you join the company, will indicate so. If your employer offers an early exercise option, it will be available to all company employees, from senior management to junior members of the team.
What are the benefits of exercising early?
The main benefit of exercising early is potential tax savings.
At the time of exercise:
When employees exercise their stock options, they may have to pay taxes on the spread between the fair market value (FMV) of the shares at the time of exercise and their options’ strike price. If their options are non-qualified options (NSOs), that spread is taxed at the ordinary income rate (same rate you pay on your salary), which can make it very hefty. If the options are ISOs, the spread will be counted as income for Alternative Minimum Tax (AMT) purposes, which may or may not result in a tax liability at the time of exercise.
Exercising early can potentially minimize this spread or eliminate it completely. Generally speaking, and assuming a company’s value increases over time, the earlier an employee exercises her options, the lower that spread will be. Since the strike price of an option is typically set to the FMV of the company’s share at the time of option issuance (and cannot be lower than such value), exercising immediately after the option is granted to an employee basically ensures that the difference between the FMV and the strike price is zero, and that means there’s no tax liability at the time of exercise (hooray!).
In order to enjoy such potential tax benefit, the employee must inform the IRS of such early exercise transaction no later than 30 days from exercising the option. Such communication with the IRS is done through an 83(b) election.
Exercising early also means that you kick off the required hold period that will allow you to enjoy a lower tax rate (capital gain rate) on the sale of your shares if and when your company exits. That rate can be 10%-20% lower than your ordinary income rate. For NSOs, that hold period is one year from option exercise, and for ISOs, it is one year from exercise and two years from the date of grant.
So both at the front end and the back end, exercising early may save you some serious dough.
Tell Me More About the 83(b) Election
An 83(b) election provides employees with the opportunity to choose to be taxed on their stock options at the time of the early exercise. If employees exercise as soon as they join the company or shortly thereafter, that choice should result in no to minimal tax since the spread between FMV and the strike price will be zero/minimal.
Don’t forget to make this election within 30 days of exercising your options. If you want to be extra careful, send the IRS two copies of the election (and a self-addressed envelope) and ask them to send one back to you with a stamp that confirms receipt. I did just that, and even though the woman at the post office made fun of me for expecting a response from the IRS during tax season, they sent it back to me promptly (I showed her!). Even though you’ve filed with the IRS within 30 days, you must also include another copy of the election with your tax return for that year.
One more note on this election. 83(b) is not a form that the IRS provides or one that you can complete and file online. However, you should be able to get a form that has all the information the IRS requires from the people who administer your employer’s compensation plans (HR or legal typically).
What’s the downside of exercising early?
Unless you have access to a very effective crystal ball, exercising early typically means you’re taking on more risk. It’s likely that employees will have more information about the company and will be able to formulate a clearer view of the company’s success probability a few years into the job than on their first day on the job. At the end of the day, most startups fail, so if your employer is a very young company and you decide to go with an early exercise, only do so if you can afford to lose your entire exercise cost.
Should I exercise early? Should I exercise at all?
While most people would agree that waking up early to exercise is good for you, early exercising your options is more of a personal decision. While we can’t make that decision for you, we do have a couple of great blogs that cover just that. Check out the When and the If and make the decision that’s right for you.
 The new tax bills may allow you to defer the federal tax payment (not the other withholdings) for a period of 5 years, but those will still be payable so you’re still incurring a liability.
 If you’re a high earner in that tax year, you may have to pay taxes even if your options are ISO.