You’re working at an awesome company. You think it might Go Big. And they’ve given you a bunch of stock options that vest over several years.
You could wait until the options vest and exercise them then. But wait! You’ve heard talk of this “early exercise” thing. Should you do it? What is it? How can it help you?
Here are the three things I want you to walk (rather, click) away from this blog post thinking about:
- How long ago were my stock options granted?
- How will the rest of my financial situation be affected by using money right now to early exercise?
- Can I afford (both financially and psychologically) to lose every penny of the money I spend early exercising?
Yes, I know this is a tedious topic. And we’d all rather read about, well, anything else. But this is important, you know? It can make a difference of thousands of dollars for you, and I’ve had enough clients ask me about it to know that It’s On Your Mind, Don’t Deny It!
What Is Early Exercise?
Let’s say you’ve just been hired and your new employer grants you options that vest over the next 4 years.
The most straight-forward approach is to wait for an option to vest and, at that point, decide whether to exercise it. If you exercise a vested stock option, you now own that stock outright. Congratulations! You’re now the owner of an incredibly unpredictable and illiquid (that is, really hard to turn it into money) security that may bring you riches but probably won’t.
When you early exercise, you pay the exercise price now for options (maybe even all of them!) that have not yet vested, and own the stock in a restricted sense (you don’t outright own it until the vesting dates finally arrive).
Not all companies allow early exercise. So the first question you should answer is: Am I even allowed to early exercise? If not, well, at least your decision is simple.
Why Would You Early Exercise?
If the employment universe shines kindly on you, your company is going to grow (possibly a lot!) over the course of several years. If you have options that vest over those same years, then as the company grows, the value of stock grows, which means the value of your options grow, which means your tax liability grows.
First thing to do in this situation is: Thank your lucky stars that you hit gold. It’s rare (despite the media impression we get) and you’re lucky and it’s largely “found money” and be appreciative, dammit!
But, to gild that lily, wouldn’t it be nice if you could pay fewer taxes on these new-found riches?
Here’s the real meat of the matter: If you early exercise, you should also file what’s called an 83(b) election with the IRS. This means:
- Now: When your company is ideally valued at very little, you pay income taxes on the accordingly small value of all your options.
- Later: When your company stock (hopefully) is worth much more, you only have to pay the lower capital-gains taxes on the increased value. That can be the difference between paying 25%, 28%, 33% or more on the stock gain versus paying 15%, 18.3%, 20%, or 20.3% on the stock gain.
To recap: The point of this 83(b) election is that you pay a higher tax rate now on a small amount of income, and a lower tax rate later on hopefully a large amount of income.
This excellent blog post goes through specific numbers in a way that I don’t want to, and would be redundant, to boot, because hey! He already did it.
Should You Early Exercise?
If early exercise is available to you, ask yourself these questions:
#1: How much money will it take to 83(b) early exercise?
If you’re a very early employee, then the 83(b) tax bill might be very small, because the fair market value (FMV) of the stock is very low. Which means this maneuver carries little financial risk.
But if you’re a later employee, and the company has raised a few rounds of funding, then the FMV might be significant, which means your tax bill would be significant, which dramatically increases your risk. Ask your HR department what the fair market value (FMV) of company shares is. It’ll likely be tied to a fundraising or a third-party valuation.
You’ll owe income tax on the difference between your exercise price and the FMV, and you’ll also need cash to exercise the options in the first place.
#2 Can I afford to front and eventually lose this money?
If the cost of early exercising (both the cost to exercise and the 83(b) tax liability) will deplete your emergency fund or crimp your ability to save for you retirement or use all the cash you were going to spend on a professional-improvement course, then you probably want to leave the gambling to Las Vegas (because that’s what it is).
Note that if you leave the company before some of your exercised stock vests, the company will likely repurchase the stock at the exercise price you paid for it (look for “right of repurchase” in your stock option grant document).
#3: How confident am I that the company is going to be a big success?
Oh, I’m sorry. I’m fresh out of crystal balls.
We’re all enthused about our start-up employers. It’s practically a requirement of employment to think you’re going to “change the world!” and “hit it big!” But much like working with “the smartest people I’ve ever known,” everyone in every start-up thinks the same thing. And you’re not all right!
[Edited 1/3/2017] For this reason, I like Wealthfront’s advice: the best time to exercise is when your company files for an IPO. If your company has gotten to the IPO stage, that’s a much more reliable predictor of success than employee enthusiasm or even prior funding successes.
Does all this sound like Charlie Brown’s teacher to you? Well, then, I have lovingly crafted this simplified decision process for you:
- Is early exercise available, and will it cost you vanishingly little to early exercise and pay the 83(b) tax liability? Do it.
- Will the cost to early exercise change your life at all significantly? Don’t do it.
Not paying attention to that 30-day deadline! [Edited 1/3/2017] If you early exercise, you must (double triple underscore, bright red flashing lights, no do-overs) file the 83(b) election within 30 days of the tax event, which basically means within 30 days of exercising the stock options, because that’s when taxes are assessed: either Alternative Minimum Tax for Incentive Stock Options, or ordinary income tax for Non-Qualified Stock Options.
Getting caught up in the company enthusiasm and not thinking objectively about the risk to your personal finances. Investing in individual companies is risky enough. Investing in an individual start-up takes that risk to a whole new level. Nine out of 10 start-ups fail. And that remaining one doesn’t always go the way of Facebook. It can get acquired at a reasonable but not astronomical valuation. (Been there, done that. Twice.)
The likelihood that your start-up will hit it big is very small. Sorry, but ‘tis the truth.
When I left my first start-up, I had outstanding options to exercise. I decided that I’d be mad at myself if the company hit it big and I didn’t get any piece of that action, but I’m too conservative to risk a lot of money. So, I exercised all my cheapest shares, for a grand total of $300. Lo’ and behold, 5 years later, that $300 got me an 800% return!!! Which is say,about $2500. I would have been better off, in retrospect, exercising all my options, but that 20-20 hindsight doesn’t mean I made the wrong choice back then.
My point here is, well, two-fold: One, I am no judge of company success and two, it’s not all or nothing: you can bet on your company to the extent it doesn’t risk the rest of your financial success.
There’s no friggin’ 83(b) form! True enough. The 83(b) election is not accompanied by a lovely, Google-able 83(b) form from the IRS. But either your HR department can provide one (companies often facilitate early exercise), of you can use this sample letter from the IRS.
Is it just me, or does the phrase “early exercise” just sound funny after you’ve read it a bunch of times?
As you might imagine, taxes weave their little fingers through much of your financial life in ways it’s hard to anticipate, and you can bet this issue is no exception. So, for anything but the most basic of decisions on this issue, I highly encourage you to work with an accountant or lawyer who specializes in stock options (they exist!).
This firm’s blog is great for understanding how stock options work, in particular early exercise and the 83(b) election.
Question: How do you feel about betting on your company? You can leave a comment below.
Do you want a financial planner who can not only help you invest in a low-cost way, but who focuses on your larger financial picture, including your career opportunities? Reach out to me at firstname.lastname@example.org or schedule a free 30-minute consultation.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner and/or an accountant for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer.