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Taking steps to early exercise

Lesson in Course: Finance at work (advanced, 5min)

I now understand the importance and the benefits of early exercising. How do I put together a plan to do so?

Eureka!

What it's about: An actionable plan to cover our bases when deciding to early exercise.

Why it's important: If we fail to file an 83(b) in time, we lose all our tax advantages.

Key takeaway: Start preparing a draft 83(b) election as soon as we know we plan to early exercise

To make sure we receive the full tax benefits to early exercise, we need a plan of action to make sure we are doing everything correctly. In order of importance, we need to prepare ourselves to make a decision, be able to pay for the shares and get our taxes straight with the IRS. Let's refer to our checklist below.

Checklist:

  1. Decide how much to early exercise
  2. Come up with enough cash to cover the total exercise cost
  3. File an 83(b) election with the IRS
 

Deciding on how much

Most startup employees make a decision on how much to early exercise based on the total cost required to exercise and their risk tolerance. To exercise our shares, we need to pay the company the total exercise cost or the total number of shares being exercised multiplied by the strike price of each share.

Amount used to exercise should be based on our goals
Total exercise cost example

If we have 10,000 shares vesting over 4 years, with an average strike price of $0.50 per share, our total exercise cost would be $5,000.

10,000 shares x $0.50 = $5,000 to exercise all 10,000 shares. 

At this point, we can decide to early exercise all of our shares or just a portion of our shares. 

Example of exercising a portion

In the example above, we have 10,000 shares vesting over 4 years with a strike price of $0.50. Let’s assume we can only afford to pay $3,000 for these shares. We can choose to early exercise 6,000 shares out of our total 10,000 shares for the time being.

Coming up with the cash

Cash should be set aside in a checking account that is easily accessible.

Cash needs to be settled and available

For those of us who also invest on the side, coming up with the cash to early exercise may require us to sell existing investments or assets. We also need to be prepared to set aside enough cash to cover any taxes.

Tax considerations example

Let's say the $3,000 we have on hand is actually tied up in an S&P500 ETF. 

Selling the shares will require us to pay long-term capital gains tax of $300. We need to set aside $300 for end-of-year taxes and use $2,700 to early exercise 5,400 shares.

After the trade settles, we need to transfer the money to our checking account.

The cash, if being transferred from another account should be fully settled and available. 

Filing the right tax statements

The last and most crucial step is to file an 83(b) election with the IRS.

Alert the IRS on no future exercise taxes
What is 83(b)?

An 83(b) election is a letter to inform the IRS of our cost of purchasing the shares and when we purchased the shares. 

An 83(b) election is essentially what allows us to claim the tax benefits of early exercising. This very important form must be filed within 30-days of exercising! Failure to do so may mean that we're on the hook for taxes.

Sample 83(b) election

Two copies of the letter must be mailed to the IRS after they are filled out, printed, and signed. A pre-stamped return envelope must be included as well. Once the IRS receives the 83(b) and files it away, it will return one of the signed copies stamped with an acknowledgment and the date of receipt.

 

Actionable ideas

We can limit the risk of losing our total exercise cost while working at a very early stage company by early exercising a portion of our shares and waiting to exercise more as the company matures and hits milestones. The trade-off with partial early exercise is that we will end up paying more taxes in the future. However, that also generally means that the company is successful enough for us to sell our shares. 

As we start planning to early exercise, we should be drafting an 83(b) election so that we don't forget and miss the deadline.

 

Glossary

What is 83(b)?

An 83(b) election is a letter to inform the IRS of our cost of purchasing the shares and when we purchased the shares.