Early exercising is when you exercise your stock options before they vest.
This may increase your potential gains by minimizing your overall taxes, as well as decrease the upfront costs when you exercise.
Early exercising is something not normally possible: companies have to specifically allow it. Ask your employer or check your option grant if you’re not sure whether this is the case for you.
If you want to get the full picture of how your stock options work, read our Stock Option Starter Guide.
Important: file an 83(b) election if you early exercise
If you early exercise, make sure to file an 83(b) election within 30 days. This is a formality that makes your early exercise official to the IRS. If you don’t file the election in time, you may lose the benefits of early exercising!
What is the strategy behind early exercising?
You may early exercise to:
- Keep the upfront costs of exercising low.
- Minimize your overall tax bill, thus maximizing your stock option gains.
Especially when your startup is in an early phase, the upfront costs of exercising early may be negligible since you may only have to pay the strike price of your stock options.
Having low upfront costs is great: it means you don’t need as much cash when exercising pre-exit, and you don’t risk losing as much money in case your company fails to have a successful exit.
How does the early exercise strategy work technically?
Exercising your incentive stock options early may minimize how much you'll owe in that year's alternative minimum tax, because your ISO strike price will likely be close to the company's fair market value, also known as a 409A valuation.
After you exercise, if you happen to hold your shares for at least two years after their grant date, and one year after your exercise date, any potential gains you make from the sale of your shares will be taxed at the long-term capital gains rate.
When is early exercising most beneficial?
Early exercising is most beneficial when you do it before the 409a valuation of company shares rises. 409A valuations are set by an outside firm, and happen at least once per year.
But even when the 409A valuation has gone up a bit since your stock option grant, exercising early can still be better than waiting for your options to fully vest. This is because if your company is performing as expected, chances are that the 409A valuation will continue to rise over time, and your tax bill at exercise will increase with it.
Is early exercising beneficial for me?
Secfi has a free Exercise Timing Planner that helps you determine that. If your company allows early exercising, the planner can help you compute the difference in potential gains between exercising today, versus waiting for your company to exit.