An Early Engineer’s Guide to Early Exercise
Welcome, bright-eyed engineer, to the world of early-stage startups! Hopefully you’ve met the team, gotten your first_name@ email address, submitted your first pull request, and frantically reverted your first pull request. You’re now faced with the most consequential financial decision of your life to date: Should you early-exercise your stock options?
When I made this decision, I was astounded by how little advice there was online. Most unfathomably, there was not a spreadsheet modeling the cost and benefits of early exercise. Now, what engineer doesn’t love a good Excel model? Well just you wait, my financially-savvy friend, because I’ve built one for you!
So what is early-exercise, if not some masochistic early morning CrossFit workout? When you early-exercise, you purchase some or all of your unvested options upfront and then receive the shares at vesting time (you should have received a vesting schedule when you joined). Let’s say you’re granted 100k options at a strike price of $0.25, and a vesting period of 4 years. If you early exercise, you write your company a check for $25k (100k shares X $0.25 strike price/share ) and turn all of your options into shares. You still get the shares according to your vesting schedule (assuming the company makes it that far — more on that later!), you just pay upfront.
Now, why do you want to pay upfront? To avoid taxes.
You can avoid short term capital gains tax and can alleviate the dreaded alternative minimum tax. Before I go on, official disclaimer: I’m not an accountant. I don’t pretend to be one, and I even try to avoid dressing like one. So if you use my model and wind up having to pawn your prized chihuahua to make rent, don’t sue me. (But seriously, sorry about the dog.)
There is no deadline on early exercising, but as you’ll see below, it’s most advantageous to do it before your company gets re-valued by the government. This typically happens every year, and during substantive financial events (new round of funding, large customer check, etc). Check with your founders to see when the next 409a valuation will be. If it is more than 2 months away, hold off on making this decision. You should make the decision as late as possible, because by then you’ll have more information on the state of your company and the market.
Reason #1 to Exercise Early: Avoiding Short-Term Capital Gains Tax
If you sell an investment within a year of purchase, your earnings are taxed as regular income. But if you hold onto the asset for a year or more before selling, you instead pay the long term capital gains tax rate, which is typically lower than your income tax rate. The Federal rate is 15% for most income groups, while the state rate varies (here’s a calculator). Your long term capital gains rate is likely to be significantly less than your income tax rate.
You can get long-term capital gains treatment for your equity if you meet both of these conditions:
(1) Hold for 2 years after grant date
(2) Hold for 1 year after exercise
By early exercising, you start the clock on (2) earlier. This matters if you want to sell your shares in a hurry, say because you need the money to exercise more shares. By exercising early, you get taxed at a lower rate when selling your shares.
Reason #2 to Exercise Early: Alleviating Alternative Minimum Tax
The other financial reason to early exercise is to alleviate alternative minimum tax (AMT). In the 60’s, Nixon and his Republican Congress were ticked off by wealthy Americans using loopholes to dodge taxes. To fix this, they implemented a simple flat tax, devoid of all the special-interest exemptions baked into the main tax code. The IRS calculates your taxes in two ways: The standard graduated income tax, as well as this alternative minimum tax. You must pay the higher of the two.
The difference in exercise price and exercise-time valuation is treated as income in the AMT calculation. In other words, you pay AMT on the spread between the exercise price and current valuation. A quick example to make you realize how crazy this is: Let’s say you exercise your 100k options with strike price of $0.25, and the company is currently valued at $1 per share. In the AMT calculation, you’ve spent $0.25 * 100k = $25k, and have earned $1 * 100k = $100k, thus you owe taxes on $75k of earnings. But wait, you haven’t sold your shares yet! You’ve made exactly $0. Regardless, you’ve got to pay taxes on this $75k of earnings.
You pay AMT on the spread between exercise price and current valuation. The current valuation is set by the government, typically using the Black-Scholes Model. Because your strike price is set to the valuation at the time you join, by early exercising this spread will be 0. So exercising your options will not cause you to hit AMT.
AMT is the most common reason why employees choose to early-exercise. There is an integral fact that is oft-overlooked, however: AMT is refundable!
If you pay $15k of taxes in AMT, and your regular taxes would have been $10k, you will receive a tax credit for $5k. You can apply this credit to your regular taxes in future years when you don’t hit AMT. Even though it is refundable, AMT is still nasty. You may not have the cash on hand to both purchase your options and pay AMT, making it difficult or impossible to exercise. And the amount you pay in AMT is tied up, meaning you can’t invest it. By early exercising, you can avoid AMT.
How to Calculate AMT
AMT is simple in principle, but complicated in practice. The IRS has provided a handy AMT Assistant, but here’s a quick-and-dirty approximation:
(1) Add your taxable income to your total deductions. This is your taxable amount.
(2) Subtract the exemption amount of $54,300 from the taxable amount. Add to this 25% of (income — phaseout_income), where phaseout_income is currently set to $120,700. These numbers are for tax year 2017 — for other years, check with the IRS.
(3) Take 26% of this number. This is your AMT.
Now compare this number to the amount you’d pay in regular taxes. You pay the greater.
A reader created this web app to calculate AMT using this approximation.
Some states have an AMT, but it typically won’t affect you unless your income is very high (>$500k).
Reason #3 to Early Exercise: Avoiding the Golden Handcuffs
Early engineers at rapidly growing companies are often imprisoned by “golden handcuffs.” Options typically expire 90 days after leaving a company. An early employee will find herself in quite a pickle when she wants to leave: She’s worth millions on paper in stock options, but to keep the equity the employee must convert the options to shares. She must both pay to exercise the shares, and will also be hit with a hefty tax in AMT. This total can be so great that it’s financially infeasible to leave the startup, leading to the proverbial golden handcuffs.
When early exercising, you pay the exercise price upfront, and also pay no AMT. You’re free to leave the company at any time, and hold onto all vested shares.
You should check what your company’s option expiration policy is. While 90 days used to be the standard, many companies are moving to more employee-friendly policies. At Pinterest, your options don’t expire until 10 years after leaving. At Cardiogram, it is 2x your tenure.
By early exercising your options, you get more flexibility in your career by avoiding the golden handcuffs.
The Model
As promised, I’ve codified this knowledge into a model. Now, before you bury yourself in the numbers and formulas, there are some assumptions you should know about:
(a) You’re receiving Incentive Stock Options (ISOs), not Nonqualified Stock Options (NSOs). AMT does not apply for NSOs, though there are some serious downsides to them.
(b) Your strike price is high enough to matter. If you join pre-funding, your strike price is going to be so low that the cost of early exercise is marginal. This is the case founders are in, and it’s a no-brainer to early exercise.
(c) Constants like dilution, tax rates, and market gains are assumed. Before using the model, you should modify these values in the Assumed Constants page.
Without further ado, here is the model. You should make a copy of it and modify the numbers under Your Values and Assumed Constants.
I’ve included 3 common scenarios:
(1) Early Exercise Everything, where you early exercise your entire stock grant when your strike price is equal to the current share valuation. Notice that there is no AMT in this case, though there is a significant opportunity cost to exercise, wherein your money is tied up in your company and so cannot be invested.
(2) Exercise and Hold at Vesting Time: In this approach, you exercise your shares as soon as they vest, then hold the shares until an exit opportunity. The opportunity cost of exercising is lower in this case, however you must pay AMT.
(3) Exercise and Sell at Exit: The most risk-averse approach, where you hold onto your options until an exit opportunity (acquisition, IPO, round of funding), when you exercise your options and immediately sell the shares.
What if the company fails?
So you’ve plugged your numbers into the model and noticed that all 3 cases give you exorbitant payouts. The catch, of course, is that they assume your company has a lucrative exit. What happens if the company fails?
There are three expenditures talked about in this post: Exercise price, capital gains, and AMT. Let’s walk through each of these in the case that the company fails:
You will lose the amount you paid to early exercise. Technically, the company has the right to repurchase unvested shares, but if they’re failing they won’t have the money to do so. In the slightest of silver linings, you do not pay capital gains tax because, well, you have no capital gains. As for AMT, as discussed above you can still get these taxes back through a tax credit.
This is what makes early-exercise risky. You should never early-exercise an amount larger than you would be comfortable losing.
That’s all!
Exercising early means you shell out a lot of money today, which you don’t get back if the company fails. And it ties up money that could otherwise be invested in the market. There are, however, some very good reasons to early exercise:
(1) Minimize capital gains taxes
(2) Avoid hitting AMT
(3) Career flexibility
I’ve given you the means to decide whether early-exercise is the right move for you, but there is no one-size-fits-all answer. Run the model, talk it over with your founders, and comment with any questions.
If you found this useful, share it with your friends who are starting jobs at early stage startups.
And if you notice any inaccuracies in this article or the model, leave me a comment.
Huge thanks to Anisha White and Omer Zach for helping me edit this post.
