In our careers, there may come a time when we decide to work for a startup and forgo a higher salary offered at a more established company for something more exciting and flexible. If the startup is successful, then our bet has paid off. Our equity, or ownership in the company, will be worth much more than the wages we left behind.
Before we call victory, the large payout from our stock sale can result in extremely high taxes—over a 50% tax rate if we live in a state like California or New York. Yikes! The good news is that we can early exercise as a strategy to shield ourselves and prevent losing so much of our hard work to taxes.
Normally, option grants are tied to a vesting schedule, which is a timetable of when we would formally receive shares. Early exercising allows us to exercise all of our vested and unvested shares by paying the strike price. By doing so, we are effectively paying for our stock now and lock in our taxable gains now. In most cases when people elect to early exercise, the difference between the strike price and the FMV is $0 or a very small amount.
How does early exercising work?
Early exercising when we receive our stock option grants closes the loop on how much tax we owe for exercising. The moment we receive our option grants, the strike price of our options and the value of the common stock (FMV) are usually the same. The taxable difference between the two is $0, and we'll effectively owe no taxes to exercise. When we sell our shares, we'll just owe capital gains tax!
Who can early exercise?
Not all stock option purchasing plans provided by companies allow for early exercise; however, it's becoming more common to have them than not.
If the company allows it, anyone can take advantage of the tax breaks and choose to early exercise. To do so we would need to notify the company and come up with a plan. We may need some assistance from the company; however, we can do most of this ourselves.
The QSBS bonus
Early exercising also offers the extra bonus of starting the clock on our QSBS exemption.
QSBS exemption is granted by the IRS to startup employees as a way to avoid paying up to $10 million in taxes from the eventual sale of stock in a startup. One of the requirements is that we need to hold the stock for five years before we sell.
What if we leave the company?
If we had chosen to early-exercise, we are refunded the cost for the unvested shares before we leave. Here's a quick example.
This flexible arrangement allows us to not have to factor in tenure at the company before early exercising.
The risk to early exercise
Early exercise provides a lot of benefits and also comes with its risks.
Startups are very risky businesses and in many cases even with subsequent funding rounds, a startup may fail to create a profitable business. In which case, the business eventually has to shut down, and we lose our money. When we decide to early exercise, we need to be ok with the possibility that we can lose all of the money we've paid to exercise and that it can be years before we can see our money back.
Early exercising is a very powerful strategy that allows us to save on future taxes. However, with the risks involved, it could be a good idea to split up our early exercise strategy to cover what we can afford to lose. We don't have to early exercise all of our options grant at once. We can elect to only early exercise 25% now and another 25% next year. We can also decide the number of shares to be exercised based on the cost in dollars that we are comfortable risking. This allows us to lock in some tax savings now while opening up the opportunity for us to wait and see the direction of the company before we risk it all.
Regardless of how we feel about the future of the company, we should do ourselves a favor and check in with our company's legal department to see if our stock option plan allows for early exercise. That would give us a clear understanding of our available options for the future.