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Guide to Early Exercise

Why you should consider offering early stock option exercise to your employees.

We are often asked about the pros, cons and other considerations of offering

early exercise⁠

- the process of buying or selling shares of stock under the terms of that option contract before its expiration date - of non-vested stock options to seed stage employees. We talked to founders, VCs, and finance experts to collect different perspectives in hopes of providing some facts and advice. This guide is geared towards seed stage companies because once a company grows and becomes more valuable, the complexity of doing early exercise from an employee and accounting standpoint becomes exponentially more complicated. We err on the side of providing every employee the most flexibility in terms of financial choice and think early exercise is a good option to offer employees. As always, if you have any comments or suggested updates, please contact

beth@homebrew.co⁠

Disclaimer: This is not tax or legal advice. Please consult your own experts. Additionally, early exercise benefits are geared towards people with access to capital. This incentive only makes sense for candidates with knowledge of how stock options work and the implications of early exercise.

Why we think this is a good idea

The Pros

Taxes. The main benefit of exercising options early if you are an early employee at a seed stage company is that you will qualify for long-term capital gains treatment earlier than you would if you waited to exercise. In other words, by exercising early, you get taxed at a lower rate when selling your shares. You are starting the clock on the holding period. If the stock is held more than one year from the exercise, then the gains on that stock are taxed at the lower tax rates for long-term capital gains. The capital gains rates are zero percent, 15% and 20%.

Capital gains⁠

refer to a rise in the value of a capital asset (investment in this case) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. (

https://blog.visor.com/equity/tax-early-exercising-isos/⁠

)

Secondary tax incentive. When the exercise price and the company valuation are the same (the company’s valuation has not increased since your grant price), there’s no immediate tax bill to pay on the equity.

Recruiting. Early exercise is a powerful recruiting incentive because it is economically compelling. The cost basis of equity is low and early stage employees see this as a competitive advantage. The exercise price is typically low as well. If you join a company early and want to exercise, make sure you are really early -- before they raise considerable funding. If you are getting in with a low exercise price, you are at an advantage over an employee coming in later stage with a higher exercise price. It will cost the earlier employee less to exercise his options.

The Cons

Exercising early may cause financial stress for certain employees. If exercising early causes financial hardship, then it is not recommended. Don’t max out a credit card or borrow money. If this causes financial stress, don’t do it.

ISOs vs. NSOs. These two types of stock receive different tax treatment and one is more favorable than the other. What exactly is the difference? Expand this bullet for more details.

ISO - An incentive stock option is a type of employee stock option with a tax benefit that, when exercised, it isn’t necessary to pay ordinary or capital gains. However, when exercising ISO’s and the exercise price is less than the current fair market value, you may be subject to AMT (

Alternative Minimum Tax⁠

) adjustments. Also, if you sell the stock purchased through the ISO and you achieve a qualifying disposition [as described elsewhere], the gain on sale will be treated as capital gains [rather than ordinary income].

NSO - A non-qualified stock option is a type of

employee stock option⁠

where you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option

So what does this mean? It’s out of your control what type of stock your company grants you. If employees are offered early exercise, ISOs (incentive stock options which receive favorable tax treatment) automatically become NSOs (non-qualified stock options which do not receive favorable tax treatment) if the total option grant is over $100,000. According to Investopedia, there are 2 types of

qualifying disposition⁠

for ISOs:

A sale of ISO stock made at least two years after the grant date and one year after the options were exercised

A sale of ISO stock that does not meet the prescribed

holding period⁠

requirements.

The downside for employees grows if they aren’t getting liquidity. If you early exercise and the company fails, then you are SOL.

Accounting Impact/General Housekeeping. A stock “buyback” or “repurpose” is a way for companies to return capital to its shareholders. A company uses cash to buy its own shares. The process is difficult to manage if your company lacks sophisticated legal counsel. It’s easy to make mistakes when the process is misunderstood or disorganized. Why and when would a startup do a buy back? Potentially where employees wanted cash out at current valuation of company X instead of watching their share value go under -- such as in the case of an unsuccessful IPO.

Other Considerations

Extended exercise

While the standard amount of time one has to sell their options after they quit or leave the company is 90 days, some companies offer an extended exercise period. For example, after a certain amount of vesting (2-3 years), an employee can qualify for extended exercise. Getting too creative though can have unintended consequences in terms of retention, incentives and cap table.

Amplitude, Pinterest, Square and Coinbase are examples of companies with 10 year exercise windows. What is the impact? For one thing, people who want to leave (who otherwise would have stayed because they would have to forfeit their options) will leave. The company creates a culture of people who are engaged and really want to be at the company vs. a company made up of employees staying for the wrong reasons such as the “golden handcuff syndrome”. Additionally, people who leave a company will still have a stake in the company and feel like a participant in the company’s success. Former employees are more likely to refer employees and have a strong alumni group where they still have an emotional and financial connection to the company.

What are the downsides? There may be increased attrition for employees who already have one foot out the door. Companies have seen a surge in administrative costs to revise stock plans and track stock awards. Additionally, you need to consider shareholder dilution. When an employee quits and doesn’t exercise his options, the shares can be used to restore the plan’s share reserve pool for future hires.

Legal/Delaware Law

One of the reasons lawyers dissuade employers from offering early exercise is:

Section 220 of Delaware Law⁠

. It opens up risk for a shareholder suing the company for access to books and records.

Conclusion

There are strong opinions on both sides regarding founders letting employees early exercise their options. However, we believe you should give your employees the opportunity to sell their options before their expiration date. We promote creating an environment that is employee centric and provides a flexible environment. If you do offer this to your employees, make sure they understand all of the implications. You don’t want an employee putting herself through financial stress to buy her options. As a company, make sure you know how to manage the process from a legal and accounting standpoint. The process can be complicated and employees may need hand holding along the way.

⁠

Glossary

⁠

Capital Gains⁠

- a rise in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold.

⁠

ISO⁠

- An incentive stock option (ISO) is a type of employee stock option with a tax benefit that, when exercised, it isn't necessary to pay

ordinary income⁠

tax. Instead, the options are taxed at a

capital gains⁠

rate.

⁠

NSO⁠

- A non-qualified stock option (NSO) is a type of

employee stock option⁠

wherein you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option.