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Early Exercise and 83b

February 16th, 2017
money, startup, taxes

This is a post where I'm trying to figure out what I should do from a tax perspective. I'm not that knowlegable about taxes, but I still have to make a tax-relevant choice. So please read this as "Jeff writes down what he's currently thinking about how to make this decision" and not "Jeff tells me how to decide whether to early exercise."

Update 2017-03-07: Ben Kuhn has a much better post, Stock options are really complicated. Go read that instead.

Update 2017-02-17: The modelling in this post is wrong to the point of not being useful. I had thought that the reason to exercise early was to get capital gains treatment on options, but ISOs already have this if you're careful with them. The reason to exercise early is the alternative minumum tax.

I recently started at a startup, and as is typical part of my compensation is in the form of stock options vesting over four years. I have two choices about how to handle this:

At first glance this seems kind of counterproductive: why would I want to pay the strike price now, instead of waiting until I exercise? The thing is, there are two different tax rates involved. If I exercise the shares now and file an 83b, then I pay no tax now (I effectively just bought some stock at fair market value) and when I eventually do sell the shares I'm taxed at the long-term capital gains rate. If instead I don't do anything, then when I eventually exercise and sell the shares [1] I pay (much higher) regular income tax on their growth.

On the other hand, the company might not succeed. Then I'll have paid thousands of dollars to buy shares that aren't worth anything. Or I might leave the company before four years have passed, giving up thousands of dollars of stock that I've paid for but hasn't vested. I don't expect either of these to happen, but the outside view suggests something like a 50% chance.

So, what does this look like financially? Let's say there's a 25% chance of the company doing really well and exiting for $1B in five years, a 25% chance of $300M, and a 50% chance of failure. How much money do I have in five years?

So, with that model I should early-exerise. But this ignores donations! Donations do two things:

Ignoring donations, I come out ahead by $58k by early exercising, while counting donations I'm ahead by $80k.

Of course, the real tricky part here is the model of how much the company is going to be worth. The company might be more likely than 50% to fail, but it also might be worth as much as, say, Western Union, at $10B. I'm not great at handling tax details, but I'm really not good at valuing companies! Not early exercising is in some sense the 'safer' choice, but of course so would have been staying at Google.


[1] The options have a ten-year exercise period, so there's nothing that would push me to exercise the options without immediately selling them.

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