Then this gives 5 distinct moments at which you could exercise:
When should you exercise your ISOs?
You could exercise at any of these points in time – but the tax implications would be different at each.
Depending on when you exercise, the amount of cash you need to exercise as well as your net gain will change.
Here’s the amount of cash you’d need to exercise at A, B, C, D or E:
If you wait all the way until you sell (point E), you don’t need any cash to exercise — because you can cover the costs with your proceeds.
But if you exercise before selling, you need to pay out of pocket.
And the higher the 409A, the more cash you need. (Because you trigger a higher tax bill – but more on that below).
So why exercise before selling?
Because if you don’t, you end up with the lowest possible net gain:
If you exercise at least 12 months prior to selling – in this case at A, B and C – your net gain is higher.
In summary, here's what happens depending on when you exercise:
Normally, the money you make from ISOs is taxed just like your salary.
But if you exercise your ISOs at least 12 months before selling them – and sell them at least 24 months after grant – you get a tax discount.
That can increase your net gain by up to 27 percent – that’s what we saw in the green bar chart.
That’s what we saw in the red bar chart – rising costs over time.
Essentially, exercising before an IPO is a trade-off: it means paying some tax now so you’ll pay less tax overall.
In our example, this is what the taxes do depending on when you exercise:
You might want to stare at that for a minute to grasp what’s going on – this is confusing stuff 😵
If you work for a constantly growing startup, you can maximize your net gains by exercising in advance of the exit.
And the earlier you do this, the less cash you need.
Of course, $206k or even $416k is a huge amount to pay for your ISOs.
Unfortunately, these are pretty common numbers for employees at the most successful and high-growth startups.
Even if you have that kind of money, putting your personal savings on the line is risky since it’s not guaranteed that your company will actually manage to reach a successful exit.
So what do you do if you still want that tax savings? Or what if you recently left your company and now have a deadline to exercise your NSOs?
That’s exactly why exercise financing exists, which is what we offer at Secfi.
Here’s how exercise financing works:
We make money only if there is a successful exit. If there is, you’ll pay us back more than the original amount. (But because of the tax savings, you’re often still at a net benefit vs not having exercised).
If there’s no exit, you don’t owe us anything (and we’ll take the hit).
In the example above, we made two assumptions:
Regarding #1, most startups never get to that point.
That’s why exercising early is risky. If the company goes out of business, you’ve lost the money you spent.
If you want to exercise your ISOs but don’t want to risk losing money, non-recourse financing is a solution.
Regarding #2, sometimes the 409A valuation of a company temporarily dips. This means you can exercise at a lower cost, so in that scenario waiting actually makes it cheaper.
If you are long-term optimistic about the company, you should expect the 409A valuation to go up – unless you foresee a specific reason why the company would take a hit in the short term.
Now that you’ve got the big picture, let’s dig into the details of just how ISOs are taxed…
ISOs are taxed twice:
At exercise, ISOs are taxed at alternative minimum tax (AMT) rates. The higher the 409A valuation of your company, the more you owe.
When you make money selling them, they’re taxed at ordinary income rates (the highest possible rate, just like your salary).
If you exercised them at least 12 months prior to selling (and sell them at least 24 months after grant), you pay long term capital gains rates instead. That’s a lower tax rate, increasing your net gain by up to 27 percent. More details on how this works below.
Whatever you paid at #1 will be subtracted from your liability at #2 – your exercise tax acts like a prepayment for your future sale tax. (You’re not double taxed!)
No. There’s no tax due when your company initially grants you the ISOs (i.e. awards you with them).
No. After grant, most ISOs follow a vesting schedule that dictates when you actually ‘get’ them. But when they vest, there’s still no tax due.
Let’s go through it step by step:
When you exercise an ISO, you pay its strike price to your company to buy a share. Say you have ISOs with a $3 strike price:
But even though you’re not making money, the difference between the strike price and the current 409A valuation is considered a phantom gain (also known as the spread) by the IRS.
Say the current 409A valuation is $35 per share. If you pay $3, you’re making a $32 phantom gain in the eyes of the IRS.
This phantom gain gets taxed. And that tax is called the alternative minimum tax (AMT).
Impressive how complicated they managed to make this, no? A true work of fiscal art...
If you’ve made it this far, it’s time to dive into:
You might not have heard about the AMT. It's a tax you normally don't encounter, but it kicks in when exercising ISOs.
It’s a weird tax with its own set of rules.
In this guide we’ll just share the takeaways.
For our clients in California, the AMT is usually ~30-38 percent. We’ll assume 35 percent in this article.
In our example, a 35 percent rate means that each ISO you exercise builds up $11.20 of AMT:
The $7,000 here is just an example. Your AMT threshold is probably a very different dollar amount. It totally depends on your tax situation for the year.
In fact, the AMT threshold isn't really a thing – as in, it's not defined and set by the government. Rather it's a result of the inner workings of the AMT, which effectively give you a threshold.
For the purposes of this guide though, all you need to know is that:
Say in total you have 15,000 ISOs. (The rest of the numbers are the same as before: $3 strike price, current 409A valuation is $35, and your AMT threshold for the year is $7,000.)
If you exercise all 15,000 ISOs, then:
But you only have to pay the AMT that surpasses your $7,000 threshold, so in the end your tax liability is $161,000 ($168,000 − $7,000).
Adding the taxes to the $45,000 strike price, and your total exercise costs are $206,000.
Note: The tax you pay when exercising isn't additional. It’s frontloaded. That means it gets subtracted from the tax you owe when you sell your shares at a gain, and won’t affect the overall net amount you make.
No. They’re often touted as such, but that’s a dangerous misconception.
The idea is that they are in principle tax-free, and the AMT is just an "exception" that kicks in if you exercise a lot of ISOs (driving the AMT beyond your yearly threshold).
The problem is that many employees reach that threshold pretty quickly.
Sometimes employers don’t even notify their employees of their ISO tax liability. And it’s your responsibility to pay this to the IRS.
In some cases, even tax advisors aren’t aware of this. We’ve heard horror stories of accountants letting their clients know that they owed an extra $60K — the day before taxes were due.
If your company keeps growing, then exercising your ISOs becomes increasingly expensive over time.
And the faster the company grows, the worse it gets.
This is because of the 409A valuation. The higher the 409A, the larger your phantom gain, the more tax you’ll owe.
The 409A is updated at least yearly and reflects company growth. If the company is in a better place than last year, the 409A will rise.
(The 409A valuation is an appraisal of the value of a company share for tax purposes. By law, your employer is required to have it re-assessed by a third party at least once a year – or when something substantial happens to the company, like a new funding round.)
Say the 409A valuation of your company grows from $35 now to $50 one year later and $75 two years later:
Then the total cost to exercise your 15,000 ISOs (including AMT) grows from $206,000 to $284,750 to $416,000:
Exploding exercise costs effectively lock you out from exercising your ISOs.
This is especially a problem at high-growth startups.
A higher 409A valuation means more taxes, but this also works the other way around. A lower 409A means less taxes.
And if the 409A is equal to your strike price, you pay no taxes at all (because your phantom gains zero).
That’s the case when you’re first granted your ISOs, because your strike price will be set to the 409A valuation at the time. So if you exercise before the 409A valuation goes up, it’s tax-free.
You can only do this if your company allows early exercising: exercising options before they vest.
At most companies you’ll have to wait for your ISOs to vest instead. But by that time, it’s likely the 409A has already increased.
⚠️ Warning: if you early exercise, you need to file an 83(b) election with the IRS within 30 days. This makes it official. If you forget to file it, you’ll still be taxed when your ISOs vest in the future.
In the above examples, we’ve used an effective AMT rate of 35 percent, which is what we often see among our clients in California. But it really depends on:
When you make money by selling your equity in an IPO or acquisition, your gain – ie. the sell price minus strike price – is taxed.
With ISOs, your gain gets taxed either as:
By default, you get the ordinary income tax rates – that's the highest possible tax rate, and the same as your salary.
If you exercised your ISOs at least 12 months before selling them, you get the lower long-term capital gains rates.
Lower rates means your net gain is higher: the gain can be up to 27 percent.
If you exercised before and already paid taxes over your phantom gain, then that gets subtracted from your sale taxes. (You’re not paying double tax 🙌.)
Again, let’s say you have 15,000 ISOs at a $3 strike price. And you exercised them when the 409A was $35.
After the IPO, you can sell them for $150 each.
In this example, however, you exercised less than a year from the IPO, so you don’t get the tax discount.
The money you make is taxed at ordinary income rates.
In this example we’ll use 45 percent for federal + California taxes, but the actual rates depend on your situation. Use our free Stock Option Exit Calculator for a personalized figure.
Assuming 45 percent, your situation now looks like this:
Your net gain is $80.85 per ISO.
But when you exercised your ISOs earlier, you already paid $45,000 for the strike price and $161,000 in taxes.
So if you now sell all of your 15,000 ISOs, this happens:
Now let's look at what happens if you do get the tax savings.
Same scenario, except this time you exercised more than 12 months before selling, so you’re taxed at long-term capital gains rates.
Again, the actual rates depend on your situation – in this article we’ll use 30% for federal + California.
The calculation is pretty much the same:
Your net gain is $102.90 per ISO.
Selling all of your 15,000 ISOs:
Your net gain is $1,543,500.
Exercising your options before the IPO is costly and risky, but the tax savings can be worth it.
In our example:
The difference is $330,750, a 27.3 percent gain.
For early employees at highly successful startups, the gain can be tens to hundreds of thousands of dollars.
Stock options are often explained as:
But #1 and #2 can happen at the same time – you buy the share, then immediately sell it. It’s as if you directly sold the ISO (rather than a share).
Of course, you can only do this if you wait until your company exits (otherwise its shares aren’t sellable).
This is called a cashless exercise, since you don’t have to come up with the cash to cover the exercise costs.
You immediately make money – the immediate costs are withheld from your proceeds, and you’re guaranteed to have enough cash to cover any taxes later on.
Waiting for an exit to do a cashless exercise is a popular strategy because exercising prior to the exit can be expensive and risky (after all, there’s no guarantee of a successful future exit).
Tax-wise, this means that you don’t get the long term capital gains tax discount.
The two taxable events – exercising and selling – blend into one. So since you didn’t exercise at least a year prior to selling, your gain gets taxed as ordinary income rather than long-term capital gains.
For instance, going back to our running example: say you have 15,000 ISOs at a $3 strike price. You don’t exercise them. Now your company IPOs, and you can sell your shares for $150 each.
With a cashless exercise, you buy and sell your shares on the same day. So per ISO, you pay your company $3. Immediately, you sell your share for $150, and make a $147 gross gain.
That gain will be taxed at ordinary income rates. If we again assume 45 percent for federal and California taxes, you'll hypothetically owe $66.15 in taxes.
Your net gain is $80.85 per ISO.
Doing this with all of your 15,000 ISOs means:
Your net gain by doing a cashless exercise is $1,212,750.
With tax savings (due to having exercise earlier) it would’ve been $1,543,500.
In California, ISOs are taxed at alternative minimum tax (AMT) rates when you exercise them, and at either ordinary income rates or long-term capital gains rates when you sell them.
That last part depends on the following:
If both are ‘yes’, your gain will be taxed at long-term capital gains rates. Otherwise, you’ll get ordinary income rates.
Below are the 2021 tax brackets for California and federal taxes (we’ll assume married individuals filing jointly).
California: 7% for any amount of income (no brackets)
California (same as ordinary income rates):
California (same as capital gains rates):
Phew – that was a long read! If you made it all the way here, you probably belong to the top 5 percent percentile of startup employees when it comes to understanding how ISOs work.
A short recap of how your ISOs are taxed:
If you exercised early enough (at least 12 months prior), and if the sale is at least 24 months after you were granted the ISOs, you get a discount on your sale tax and maximize your net gain.
If you wait all the way until the exit to do a cashless exercise, you won’t get the tax savings.
For growing companies, the amount of AMT you owe grows the later you exercise, because the 409A valuation grows.
So if your company is growing, and manages to have a successful exit, then the optimal tax strategy could be to exercise your ISOs as early as possible.
We hope this was helpful!
Still have questions? Feel free to hit us up for a chat in the bottom-right. ↘️