The surprise factor: Why exercising your stock options can be far more expensive than you expect
5 min
2. Add your stock options
3. Open the Stock Option Tax Calculator
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For startup employees who are not aware of how federal and state taxes apply to stock options, exercising can be on average about 8x–10x more expensive than they expect. That estimate is based on Secfi’s internal modeling of typical pre-IPO option grants and should be treated as directional only. Within that range, a total exercise cost that is roughly 3x–5x the strike price is common once strike price, potential Alternative Minimum Tax (AMT), and other tax effects are included.
You are usually taxed when you exercise your stock options because the spread between your strike price and the share’s fair market value, based on the company’s 409A valuation at exercise, is treated as income for that tax year. For non-qualified stock options (NSOs), that spread is taxed as ordinary income in the year you exercise, according to the IRS.
The cost of exercising your ISOs and NSOs is higher than just the strike price, often much higher once you factor in federal income taxes and potential Alternative Minimum Tax (AMT) on ISO exercises, according to analysis from Carta. If you have not modeled those tax costs in advance, exercising your stock options can turn into an expensive fiscal surprise.
It's why Wouter Witvoet started Secfi – he got caught by that fiscal surprise.
The startup world would be better off if every employee knew about this. To raise awareness, I shared how this affected Snowflake employees. But that's anecdotal.
So let's quantify this problem and give it a name.
If you thought you would only have to pay your options' strike price when exercising, then your surprise factor is the metric that says:
How much higher are your exercise costs, relative to what you think they are?
Definition: surprise factor = (exercise cost including taxes) / (strike price * number of options)
For instance, someone in the following situation would have a surprise factor of 8.0x:
In theory, there's no limit to this metric. When you exercise, your tax liability is driven by the 409A valuation (also known as fair market value) of the company, which can grow indefinitely.
So how large does it get in practice for high-growth U.S. startups?
I pulled a quick sample from recent users on the Secfi platform. With N=25 this is by no means representative, but it sketches an idea of the impact of exercise taxation in practice.
The sample includes employees from companies such as
The stats:
It's not distributed evenly, though – it gets especially bad for early employees at very high-growth companies. These were the worst three:
That's an almost 10x higher than expected cost due to taxes
Here's the full dataset:
It can catch you off guard in a few different ways, especially when the tax bill ends up being several times higher than the strike price you budgeted for.
Maybe you were aware that, should you leave your company, you're forced to exercise within 90 days (which is the case for 91% of startups).
Say you have 100,000 vested NSOs at a $0.5 strike price. Now if you didn't know about exercise taxation, you might have concluded that's no problem since you're able to afford $50,000 with your savings.
If you later decide to leave the company and only then learn about the potentially large tax bill you could trigger by exercising your stock options, you generally face two choices:
Both pretty disappointing outcomes after years of hard work.
And that's actually the best case.
Worse is when your employer doesn't notify you of the due tax, and you only discover this after having exercised when there's no way back. You are now on the hook for that $125,000 tax liability, regardless of whether you actually have that kind of money.
Rather, they're typical of the kind of startups Secfi often works with: late-stage companies that have been on a trajectory of high growth, and are poised for a successful exit.
Growth increases the 409A valuation, which drives the tax liability.
The average startup doesn't grow as fast. Their 409A valuation won't explode, so their employees won't experience the problem as severely.
The irony is that it's precisely at skyrocketing startups that employees have reason to exercise. At these companies the IPO tax savings can be enormous, and when a killer IPO is on the horizon, people leaving these companies don't want to see their equity go up in smoke.
The more successful the startup, the bigger the incentive to exercise – yet the harder it is to do.
It's good to be aware of the tax bill you'd trigger by exercising your stock options. You can use our Stock Option Tax Calculator, which is free.
Here's how:
1. Sign up here (3 minutes)
