Early Exercise and 83(b) Elections: Opportunities and Risks

Early Exercise and 83(b) Elections: Opportunities and Risks

For startup employees with stock options, understanding early exercise and 83(b) elections can potentially save significant tax dollars and maximize your equity value. However, these strategies come with important considerations and risks that should be carefully evaluated.

What Is Early Exercise?

Early exercise is the ability to purchase shares through your stock options before they have fully vested. This means:

• You can buy shares that you don't yet "own" according to your vesting schedule

• You gain actual shareholder status earlier in your employment

• The company retains the right to repurchase unvested shares if you leave

Not all option plans allow early exercise—this feature must be explicitly included in your option grant agreement.

When Early Exercise Makes Sense

Early exercise isn't right for everyone. Consider this strategy when:

Financial Factors Align

• Your strike price is very low (typically under $1.00 per share)

• The total cost to exercise is manageable without financial strain

• You have cash available that isn't needed for other financial priorities

• You believe strongly in the company's long-term potential

Career and Company Factors Align

• You're confident in your long-term commitment to the company

• The company has strong growth potential and promising unit economics

• The founding team has a track record of successful ventures

• You have insight into the company's financial health and runway

Tax Factors Align

• There's currently a small or zero gap between your strike price and the 409A fair market value

• You're in a position to immediately file an 83(b) election (more on this below)

• You anticipate significant share price appreciation in the future

• You're early enough in the company's lifecycle to potentially qualify for QSBS tax benefits

Tax Benefits of Early Exercise

The primary benefit of early exercise is tax-related, particularly when combined with an 83(b) election:

Without Early Exercise

1. You wait until options vest before exercising

2. By that time, the company's fair market value may have increased significantly

3. This creates a larger spread between your strike price and current FMV

4. For NSOs, this spread is taxed as ordinary income at exercise

5. For ISOs, this spread may trigger Alternative Minimum Tax (AMT)

With Early Exercise + 83(b) Election

1. You exercise immediately after receiving your grant

2. You file an 83(b) election within 30 days

3. You pay taxes (if any) on the minimal spread between strike price and FMV

4. Future appreciation is taxed as capital gains when you eventually sell

5. The capital gains clock starts ticking immediately

Understanding the 83(b) Election

The 83(b) election is a formal notification to the IRS that you're electing to be taxed on the value of property (your shares) at the time of receipt rather than as they vest.

Why It Matters

Without an 83(b) election:

• Each vesting event is a taxable event based on the FMV at that time

• As the company grows, your tax liability at each vesting date increases

With a properly filed 83(b) election:

• You're taxed only once—at the time of exercise

• Future appreciation is only taxed when you sell shares

• You potentially convert ordinary income tax to long-term capital gains tax

Critical Timing

• Must be filed within 30 days of exercising options

• No exceptions or extensions to this deadline

• The 30-day clock starts on the day of exercise, not the day you receive the option grant

Step-by-Step Guide to Filing an 83(b) Election

Filing an 83(b) election requires careful attention to detail:

1. Prepare the Election Form

• No official IRS form exists—you must create your own letter

• Include your name, address, and Social Security number

• Identify property received (company name, number of shares, date received)

• State the FMV of property at transfer

• State the amount paid for property (your exercise price)

• State the amount to include in gross income (typically the spread, if any)

• Include statement that copies are being sent to IRS and your employer

2. Mail the Election to the IRS

• Send to the IRS office where you file your tax return

• Use certified mail with return receipt requested

• Keep proof of mailing and delivery

3. Provide Copies

• One copy to your employer (the company)

• One copy for your personal records

• Consider providing a copy to your tax professional

4. Report on Your Tax Return

• Report the election on your tax return for the year in which you exercised

• Include any resulting income (the spread) on your tax return

Sample Timeline

• Day 0: Receive option grant allowing early exercise

• Day 5: Exercise options and receive shares

• By Day 35: File 83(b) election (30 days from exercise)

• Next tax filing: Report the transaction on your tax return

Potential Downsides and Risks

Early exercise and 83(b) elections come with significant risks:

Financial Risks

• Capital at Risk: You're investing cash in highly illiquid shares

• Total Loss Possibility: If the company fails, your investment could be worthless

• Opportunity Cost: Capital used could be invested elsewhere

• Liquidity Constraints: You typically cannot sell shares until an exit event

Tax Risks

• No Tax Loss Recovery: If the company's value decreases or it fails, you cannot recover taxes already paid

• AMT Implications: For large exercises, you may still trigger AMT

• Missed 83(b) Deadline: Missing the 30-day window eliminates the tax benefits

• Changing Tax Laws: Future tax law changes could impact expected benefits

Career Risks

• Departure Concerns: If you leave before full vesting, unvested shares are typically repurchased at your exercise price, not current FMV

• Vesting Schedule Changes: Company restructuring or acquisitions might impact vesting schedules

• Changing Equity Programs: Companies sometimes modify equity programs, potentially impacting your strategy

Common Mistakes to Avoid

During the Decision Process

• Misunderstanding Vesting Terms: Know exactly how repurchase rights work

• Overcommitting Financially: Don't strain your finances for early exercise

• Skipping Due Diligence: Research company health before committing

• Misunderstanding Tax Consequences: Consult a tax professional

During the Exercise Process

• Missing Documentation: Ensure you receive proper share certificates or digital records

• Improper Payment: Follow company instructions precisely for payment

• Forgetting Necessary Agreements: Sign all required documents

During the 83(b) Filing Process

• Missing the 30-Day Deadline: No exceptions are granted

• Incomplete Information: Ensure all required elements are included

• Improper Delivery: Use certified mail with return receipt

• Not Keeping Proof: Maintain evidence of timely filing

• Not Informing Company: The company needs a copy for their records

Special Considerations for Different Option Types

Incentive Stock Options (ISOs)

• Early exercise may create immediate AMT liability

• Future disposition must meet holding period requirements for preferential tax treatment

• Special reporting requirements on tax returns

Non-Qualified Stock Options (NSOs)

• Early exercise typically creates immediate ordinary income on any spread

• Withholding requirements may apply at exercise

• Future disposition taxed as capital gains

Creating Your Early Exercise Strategy

Questions to Ask Your Company

• "Does my option agreement allow for early exercise?"

• "What is the process for early exercise and how long does it take?"

• "What documentation will I receive upon exercise?"

• "What happens to unvested shares if I leave the company?"

• "Can you connect me with other employees who have early exercised?"

Questions for Your Financial/Tax Advisor

• "Given my financial situation, does early exercise make sense?"

• "What would my tax liability be with and without an 83(b) election?"

• "How would early exercise impact my overall financial plan?"

• "What documentation should I maintain for tax purposes?"

Creating a Decision Framework

1. Assess Financial Capacity: Can you afford the exercise price and potential tax liability?

2. Evaluate Company Prospects: What is your confidence level in the company's future?

3. Understand Time Commitment: How long do you plan to stay with the company?

4. Calculate Tax Impact: What are the tax implications with and without early exercise?

5. Consider Alternatives: Would investing elsewhere provide better risk-adjusted returns?

Final Thoughts

Early exercise with an 83(b) election can be a powerful strategy for maximizing the value of your startup equity, but it requires careful consideration of your financial situation, career plans, and risk tolerance.

This strategy tends to work best when:

• You join a company very early (low 409A valuation)

• Your strike price is minimal

• You're committed to staying long-term

• You have the financial resources to exercise without strain

Always consult with tax and financial professionals before pursuing this strategy, as individual circumstances vary significantly, and the stakes—both potential benefits and risks—are substantial.