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Semi related to this blog post: A lot of people don't realize that you can exercise ISOs before they vest. If you are sure that you are going to be exercising

by harryh 10y ago

Semi related to this blog post: A lot of people don't realize that you can exercise ISOs before they vest. If you are sure that you are going to be exercising your options there is no reason to wait until they vest and, in fact, there are disadvantages to doing so. As soon as you get your options (within 30 days. there is a time limit.) you tell your company you want to exercise then and file and 83B with the IRS indicating that you have done so. This avoids potential AMT taxes at the time of exercise and starts to clock on making your gains long term capital gains which are taxed at a lower rate.

lloyddobbler 10y ago
IIRC, this is on a company-by-company basis. Only some companies offer early exercise (i.e., exercising your options prior to vesting). It's a great practice to do, if you believe the company is going to do well. Goes a long way towards minimizing the AMT burden.
- harryh 10y ago
  Yes, this is true. I will add that I have found that if you ask hard enough there is a good chance that companies that say that they don't do this at first will end up allowing you to do so. There's really no good reason for them not to.
  - mnutt 10y ago
    I would imagine that the reason many companies are reluctant to do this (or at least don't advertise it) is because advising employees whether they should or should not do it amounts to giving financial planning advice. Asking hard enough probably means showing you have weighed your own financial situation and understand the risks.
    - deleted 10y ago
      [deleted]
  - hkmurakami 10y ago
    There is one "good reason". To hand cuff and trap employees. I hope that the incidence rate for this is low, but it must be non zero. (I think pre series A companies should give out RSUs and not options to avoid these situations)
    - dickfickling 10y ago
      the "early exercise" that harryh refers to carries the same handcuffs as an option grant - a (typically) four year vesting schedule. The difference is that instead of vesting "the option to purchase shares" you vest the removal of the option for the company to repurchase the shares it sold you, at the original purchase price. In other words, if I exercise early and leave after two years, the contract states that my employer can purchase my unvested shares back at the original price.
      - sgman 10y ago
        An option grant where the spread has become large enough that the employee cannot cover the tax burden upon exercise effectively handcuffs said employee to the company until a liquidation event.
      - deleted 10y ago
        [deleted]
      - hkmurakami 10y ago
        Early exercise minimizes the tax burden reason for handcuffing.
        hijinks 10y ago
        sometimes startups put the strike price below current valuation if they've raised at least their A round.
        prostoalex 10y ago
        They cannot. Backdating or artificially deflating the asset price is no longer legal. What's likely to happen is new investor extracting some special terms for their investment, receiving preferred stock that's valued higher than common stock. The company then turns around and uses the product of preferred stock price and total number of shares outstanding as the new valuation number that's "leaked" to the press. The 409A valuation of the common stock is a separate dollar figure, though.
argigg 10y ago
To state the obvious, the downside of early exercise is you might lose that money if the company does poorly.
- jjirsa 10y ago
  The downside of early exercise is if you leave before vested and your employer repurchases the shares, you're out the taxes you paid (minus some deductions in future years that will offset other gains but will still be painful for most people).
  - argigg 10y ago
    When you early exercise, don't you pay the 409a price? Why would you owe taxes at the time of exercise?
caseysoftware 10y ago
Close, but not quite. The time limit is to when you have to file the 83b with the IRS to document the early exercise. The rest of what you said applies. The key thing is that you want the delta (between exercise price and FMV) to be as small as possible. Of course, none of that matters if the company isn't going to succeed anyway. * And yes, I have done this. I early exercised all of my shares at Twilio.
- rosser 10y ago
  Slight clarification: The key thing is that you want the delta (between exercise price and FMV) to be as small as possible — at the time of exercise. If you exercise any time but (effectively) immediately upon being granted your ISOs, you're liable for the taxes on the delta between your strike price and the FMV at time of exercise. If you exercise immediately, that should be zero. But it's that delta — between strike price and FMV at time of exercise — that can factor into AMT in a particularly surprising, and often very unpleasant way. Forward-exercising and making an 83(b) election also starts the clock ticking on capital gains tax. Effectively, if you're starting at a brand new unicorn, and exercise your entire grant on Day 1, you'll only owe Long-Term Capital Gains tax (15%, instead of regular income rates — or, worse, AMT) on the entirety of your (initial) option grant, the day you hit your vesting cliff. IANA Tax Attorney, or Accountant. Caveat lector.
- harryh 10y ago
  You're totally right. I mis-spoke (mistyped?). Thanks for the correction.
andrewf 10y ago
What happens if/when you leave before all your ISOs have vested? Do you forfeit the exercise price for the unvested stuff, or does the company typically refund it?
- dickfickling 10y ago
  the company refunds it. technically, what you generally agree to when you early exercise is to give the company the right to purchase the unvested shares back from you at the original purchase price.
  - romanhn 10y ago
    The caveat is that you lose whatever taxes you paid on exercising unvested shares. Gotta be really careful with that, as the taxes could cost way more than the exercise itself.
    - harryh 10y ago
      The idea with early exercising is to not pay any taxes because you exercise at the strike price.
      - romanhn 10y ago
        Sure, but there are instances when that's not the case, e.g. early exercise implemented by company after the fact, or holding off buying until you're reasonably sure that the shares won't tank next month.
  - deleted 10y ago
    [deleted]
mbesto 10y ago
This also requires that you have the money to pay for it at that moment too right? In other words - I get 10k options at $1 strike price, in order to exercise within 30 days I need to pay $10,000. Correct?
- charliepark 10y ago
  You'll need $10K to buy the options from your company. That's "Day 1". By Day 30 you need to file 83b with the IRS. And when it's time to pay your taxes for that year, you'll need to pay the IRS the taxes on the "income" you got from exercising the options. That is, if the strike price is $1 and the current market price for the shares is $3, the IRS sees that as a $20K income you made (even though you don't actually have liquid money). If the delta between the strike price and the market price is large enough, you might actually pay the IRS more than you'll pay your company.
  - mbesto 10y ago
    So this can totally screw you if: Day 0 - Company is worth $1B (pay $10k) Day 365 - Company is worth $2B (pay taxes on $10k in "income") Day 900 - Company sells for $50M (your stock is probably worthless due to liquidation preferences)
    - overdrivetg 10y ago
      My understanding is that Day 0 is the only important day here (or actually, Day 365 doesn't matter). You pay $10K on Day 0 and you earn no "income", so you do not owe any tax. On Day 900, if your shares are worthless, you can then take that $10K as a long-term capital loss. If and how that can carry forward is something you'll want a tax accountant for. Here's some of what the IRS has to say about that, but of course - Get an Accountant: https://www.irs.gov/uac/irs-reminds-taxpayers-they-can-use-stock-losses-to-reduce-taxes https://www.irs.gov/uac/irs-reminds-taxpayers-they-can-use-s...

by harryh 10y ago

lloyddobbler 10y ago

IIRC, this is on a company-by-company basis. Only some companies offer early exercise (i.e., exercising your options prior to vesting). It's a great practice to do, if you believe the company is going to do well. Goes a long way towards minimizing the AMT burden.

harryh 10y ago
Yes, this is true. I will add that I have found that if you ask hard enough there is a good chance that companies that say that they don't do this at first will end up allowing you to do so. There's really no good reason for them not to.
- mnutt 10y ago
  I would imagine that the reason many companies are reluctant to do this (or at least don't advertise it) is because advising employees whether they should or should not do it amounts to giving financial planning advice. Asking hard enough probably means showing you have weighed your own financial situation and understand the risks.
  - deleted 10y ago
    [deleted]
- hkmurakami 10y ago
  There is one "good reason". To hand cuff and trap employees. I hope that the incidence rate for this is low, but it must be non zero. (I think pre series A companies should give out RSUs and not options to avoid these situations)
  - dickfickling 10y ago
    the "early exercise" that harryh refers to carries the same handcuffs as an option grant - a (typically) four year vesting schedule. The difference is that instead of vesting "the option to purchase shares" you vest the removal of the option for the company to repurchase the shares it sold you, at the original purchase price. In other words, if I exercise early and leave after two years, the contract states that my employer can purchase my unvested shares back at the original price.
    - sgman 10y ago
      An option grant where the spread has become large enough that the employee cannot cover the tax burden upon exercise effectively handcuffs said employee to the company until a liquidation event.
    - deleted 10y ago
      [deleted]
    - hkmurakami 10y ago
      Early exercise minimizes the tax burden reason for handcuffing.
      - hijinks 10y ago
        sometimes startups put the strike price below current valuation if they've raised at least their A round.
        prostoalex 10y ago
        They cannot. Backdating or artificially deflating the asset price is no longer legal. What's likely to happen is new investor extracting some special terms for their investment, receiving preferred stock that's valued higher than common stock. The company then turns around and uses the product of preferred stock price and total number of shares outstanding as the new valuation number that's "leaked" to the press. The 409A valuation of the common stock is a separate dollar figure, though.

argigg 10y ago

To state the obvious, the downside of early exercise is you might lose that money if the company does poorly.

jjirsa 10y ago
The downside of early exercise is if you leave before vested and your employer repurchases the shares, you're out the taxes you paid (minus some deductions in future years that will offset other gains but will still be painful for most people).
- argigg 10y ago
  When you early exercise, don't you pay the 409a price? Why would you owe taxes at the time of exercise?

caseysoftware 10y ago

Close, but not quite. The time limit is to when you have to file the 83b with the IRS to document the early exercise. The rest of what you said applies. The key thing is that you want the delta (between exercise price and FMV) to be as small as possible. Of course, none of that matters if the company isn't going to succeed anyway. * And yes, I have done this. I early exercised all of my shares at Twilio.

rosser 10y ago
Slight clarification: The key thing is that you want the delta (between exercise price and FMV) to be as small as possible — at the time of exercise. If you exercise any time but (effectively) immediately upon being granted your ISOs, you're liable for the taxes on the delta between your strike price and the FMV at time of exercise. If you exercise immediately, that should be zero. But it's that delta — between strike price and FMV at time of exercise — that can factor into AMT in a particularly surprising, and often very unpleasant way. Forward-exercising and making an 83(b) election also starts the clock ticking on capital gains tax. Effectively, if you're starting at a brand new unicorn, and exercise your entire grant on Day 1, you'll only owe Long-Term Capital Gains tax (15%, instead of regular income rates — or, worse, AMT) on the entirety of your (initial) option grant, the day you hit your vesting cliff. IANA Tax Attorney, or Accountant. Caveat lector.
harryh 10y ago
You're totally right. I mis-spoke (mistyped?). Thanks for the correction.

andrewf 10y ago

What happens if/when you leave before all your ISOs have vested? Do you forfeit the exercise price for the unvested stuff, or does the company typically refund it?

dickfickling 10y ago
the company refunds it. technically, what you generally agree to when you early exercise is to give the company the right to purchase the unvested shares back from you at the original purchase price.
- romanhn 10y ago
  The caveat is that you lose whatever taxes you paid on exercising unvested shares. Gotta be really careful with that, as the taxes could cost way more than the exercise itself.
  - harryh 10y ago
    The idea with early exercising is to not pay any taxes because you exercise at the strike price.
    - romanhn 10y ago
      Sure, but there are instances when that's not the case, e.g. early exercise implemented by company after the fact, or holding off buying until you're reasonably sure that the shares won't tank next month.
- deleted 10y ago
  [deleted]

mbesto 10y ago

This also requires that you have the money to pay for it at that moment too right? In other words - I get 10k options at $1 strike price, in order to exercise within 30 days I need to pay $10,000. Correct?

charliepark 10y ago
You'll need $10K to buy the options from your company. That's "Day 1". By Day 30 you need to file 83b with the IRS. And when it's time to pay your taxes for that year, you'll need to pay the IRS the taxes on the "income" you got from exercising the options. That is, if the strike price is $1 and the current market price for the shares is $3, the IRS sees that as a $20K income you made (even though you don't actually have liquid money). If the delta between the strike price and the market price is large enough, you might actually pay the IRS more than you'll pay your company.
- mbesto 10y ago
  So this can totally screw you if: Day 0 - Company is worth $1B (pay $10k) Day 365 - Company is worth $2B (pay taxes on $10k in "income") Day 900 - Company sells for $50M (your stock is probably worthless due to liquidation preferences)
  - overdrivetg 10y ago
    My understanding is that Day 0 is the only important day here (or actually, Day 365 doesn't matter). You pay $10K on Day 0 and you earn no "income", so you do not owe any tax. On Day 900, if your shares are worthless, you can then take that $10K as a long-term capital loss. If and how that can carry forward is something you'll want a tax accountant for. Here's some of what the IRS has to say about that, but of course - Get an Accountant: https://www.irs.gov/uac/irs-reminds-taxpayers-they-can-use-stock-losses-to-reduce-taxes https://www.irs.gov/uac/irs-reminds-taxpayers-they-can-use-s...