Startups retain and incentivize employees through equity incentives like stock options.
Stock options are the contractual right to buy stock in the future at a fixed price.
To capitalize on certain tax benefits, many employees request the right to exercise their stock options prior to vesting–a practice known as “early exercising.”
The right to early exercise may be negotiated into an employee’s option award agreement or otherwise subject to the discretion of the Board of Directors.
When early exercise is granted, the company retains the right to repurchase the shares prior to vesting.
However, there are several implications when an employee early exercises or receives the right to early exercise.
For incentive stock options (ISOs), early exercise can cause an option award to exceed the $100,000 annual ISO limitation.
ISOs in excess of $100,000 of fair market value exercisable in one (1) year are deemed by the IRS to be non-qualified stock options (NSOs).
If ISOs are early exercisable–even the right to exercise–the entire award is treated as “first exercisable” in the year the option is received.
Any shares in excess of that amount are treated as NSOs.
For example, Company A awards Employee B ISOs for 100,000 shares at a fair market value of $1.25, subject to 4-year vesting with a 1-year cliff.
Without an early exercise right, the most exercisable in any year would be 25,000 shares after the 1-year cliff.
The fair market value is $31,250 (25,000 shares x $1.25).
These ISOs have no risk of exceeding the $100,000 ISO cap and will be treated as ISOs for Company A and Employee B’s tax purposes.
With an early exercise right, all 100,000 shares would be treated as first exercisable in one (1) year.
This results in a fair market value of $125,000 in one (1) year.
Any ISO shares in excess of $100,000 (here, $25,000 worth, or 20,000 shares) will be treated as NSOs, not ISOs.
Companies have certain withholding obligations and may take certain tax deductions depending on whether the options are ISOs or NSOs.
Also, ISOs and NSOs have different tax implications.
As such, early exercising (or even just the right to do so) can throw a wrench in a company’s (and its employees’) tax planning.
Second, 83(b) elections bring a whole host of obstacles for the company.
Generally, 83(b) elections for ISOs accelerate the taxable event for Alternative Minimum Tax purposes.
For NSOs, an 83(b) locks in the income tax “spread” between the exercise price and the fair market value and starts the clock on long-term capital gains.
Further, employees may have numerous questions about 83(b) elections, such as:
- what happens if they failed to timely file the election
- what happens if the company fails to track or notify employees of their respective deadlines (even if such is an employee obligation)
These issues can create unnecessary disputes between the company and its employees.
Third, early exercise can create administrative headaches.
Early exercise does not cease the vesting of the underlying stock.
The company’s right to repurchase the stock, such as after termination or resignation of the employee prior to vesting, continues regardless.
After an early exercise, the company must implement methods to track the vesting schedule and the company’s ever-changing right to repurchase as vesting accrues over time and, potentially, for a variety of employees.
This can cause significant administrative headaches for early-stage companies with limited employees.
Fourth, early exercises can cause various accounting issues, including liability tracking, expense treatment, EPS treatment, disclosure treatment, and proxy reporting.
These accounting specifics are further elaborated here.
These considerations can (1) drastically complicate and require a revamp of the company’s accounting processes and systems (together with incurring expenses with CPAs and tax counsel) and (2) may delay or undermine future financings when a VC’s due diligence uncovers failure to implement the necessary tax or accounting mechanisms.
In conclusion, granting employees a right to exercise options early is a tempting proposition to improve morale and get early buy-in from employees. However, companies and their leadership teams should carefully consider all the tax, administrative, accounting, and practical implications before granting their employees such rights.
While I am a lawyer who enjoys operating outside the traditional lawyer and law firm “box,” I am not your lawyer. Nothing in this post should be construed as legal advice, nor does it create an attorney-client relationship. The material published above is intended for informational, educational, and entertainment purposes only. Please seek the advice of counsel, and do not apply any of the generalized material above to your individual facts or circumstances without speaking to an attorney.