employee equity compensation in tech startups
Early exercising is when you exercise your stock options before they vest.
This may increase your profit by minimizing your overall taxes, as well as decrease the upfront costs when you exercise.
Early exercising is something not normally possible: companies have to specifically allow it. Ask your employer or check your option grant if you’re not sure whether this is the case for you.
If you want to get the full picture of how your stock options work, read our Stock Option Starter Guide.
If you early exercise, make sure to file an 83(b) election within 30 days. This is a formality that makes your early exercise official to the IRS. If you don’t file the election in time, you may lose the benefits of early exercising!
You may early exercise to:
Especially when your startup is in an early phase, the upfront costs of exercising early may be negligible since you may only have to pay the strike price of your stock options.
Having low upfront costs is great: it means you don’t need as much cash when exercising pre-exit, and you don’t risk losing as much money in case your company fails to have a successful exit.
How it works is that early exercising allows you to exercise before the 409A valuation of company shares has gone up, so the difference between it and the price of your stock options is zero. It is precisely this difference between strike price and 409a valuation that is taxed upon exercise.
Having to pay $0 in taxes at exercise, you only pay for the strike price. Additionally, if at least a year later your company has a successful exit, your payout is taxed at capital gains – the lowest possible tax rate.
Early exercising is most beneficial when you do it before the 409a valuation of company shares, has gone up since you were granted the stock options. The 409a valuation is re-evaluated every once in a while.
But even when the 409a valuation has gone up a bit since your stock option grant, exercising early can still be better than waiting for your options to vest. This is because if your company is performing as expected, chances are that the 409a valuation will continue to rise over time, and your tax bill at exercise will increase with it.
Secfi offers Exercise Pre-Exit, a free tool that helps you determine that. If your company allows early exercising, Exercise Pre-Exit helps you compute the difference in profit between exercising today versus waiting for your company to exit.
To use Exercise Pre-Exit: