Should I early exercise my ISOs?
Early employees – be it founders or initial hires – may receive a unique condition with their equity grants that allows them to “early exercise” via 83(b) election.
In layman's terms, this essentially means that you're electing to purchase your shares and pay any ordinary income tax now rather than at time of vest. The thought is that there could be some tax advantages to this strategy.
For founders with Restricted Stock Awards (RSAs – not to be confused with RSUs), this is often a no-brainer because the company is essentially worth nothing and the risk is nearly zero.
Example of early exercising RSAs:
The company has not formally raised any capital, so there is no 409a/fair market value (FMV) of the common shares, aside from the par value
Par value is $0.0001 per share
Founder has 1,000,000 shares
“Early exercising” means paying $100 ($0.0001 x 1M shares) for your shares.
Since the par value essentially equals the FMV prior to any formal valuation, the founder is assessed $0 in ordinary income tax owed and only needs to pay the purchase price. And, even better, the founder starts the clock for long-term capital gains and Qualified Small Business Stock (QSBS) treatment.
Pretty risk-free, if you ask me. (Just be sure to file your 83b election on time!)
The numbers are similar when early exercising Non-Qualified Stock Options (NSOs):
The company 409a/FMV is now $0.05 per share
Employee #1 is granted 100,000 options with a strike price of $0.05 per share
“Early exercising” means Employee #1 will pay ($0.05 x 100,000 shares) $5,000 for your shares
Since the “bargain element” or “spread” (same thing; don’t know why there are two terms!) between the 409a/FMV and strike price is equal, the employee is assessed $0 in ordinary income tax owed. Of course, Employee #1 actually has to purchase the options for $5,000 (which may or may not be trivial), but again it starts the clock on long-term capital gains and Qualified Small Business Stock (QSBS) treatment.
The risk, aside from $5,000, is also pretty minimal.
Most companies, however, offer initial employees the ability to early exercise Incentive Stock Options (ISOs) – rather than Non-Qualified Stock Options (ISOs)….and this is where things get hairy.
After founders receive their Restricted Stock Awards (RSAs), Incentive Stock Options (ISOs) are generally the next type of equity that early-stage companies offer to employees. If certain holding requirements are met (i.e. if the ISOs are “qualified”), then ISOs can be tax-advantageous and are therefore generally preferable to their cousin, the Non-Qualified Stock Option.
So it’s no wonder that companies think they are doing well by their employees by offering ISOs that can be early exercised. After all, ISOs can be “qualified” while NSOs, by definition, are “non-qualified” stock options, right?
In actuality, if you plan to early exercise your options immediately at grant, NSOs are preferable to ISOs.
Here’s why: exercising NSOs is not considered to be a positive adjustment to Alternative Minimum Taxable Income (AMTI). So when you early-exercise your NSOs, you don’t need to worry about any Alternative Minimum Tax (AMT) implications. And with NSOs, you immediately start the clock on both long-term capital gains and QSBS. This is exactly what you’re looking to do via an early exercise.
Exercising ISOs, however, does impact your AMTI and could subject you to AMT. And early-exercising ISOs does not function the same way as early-exercising NSOs.
What gives? In a 2004 IRS revenue bulletin, the IRS determined that early-exercising ISOs is effective for AMT purposes only – not for regular tax purposes.
I’ll try to explain this gobbly-gook madness in as simple terms as possible.
NSOs do exactly what you think they’ll do when you early exercise
ISOs only do what you think they’ll do from an AMT perspective – not a regular tax perspective.
This means that ISOs must be held for at least one year from original vest date and at least two years from the date of grant – even if they are early-exercised.
ISO Early-Exercise Example:
The company 409a/FMV is $1.00 per share
Employee is granted 1,000 options with a strike price of $1.00 per share
“Early exercising” means paying $1,000 ($1 x 1,000 shares) for your shares
By early exercising the ISOs when the bargain element (409a - strike price) is $0, the employee will eliminate any AMT liability in future years.
However, the clock for long-term capital gains treatment does not start upon early exercise. Rather, it only starts on the day that the shares actually vest. What this means is that, unlike with NSOs, ISOs do not automatically qualify from long-term capital gains after 1 year. In fact, a qualifying disposition must still be met for early-exercised ISOs.
The risk in early exercising ISOs is that you could still be subject to ordinary income and short-term capital gains taxation even if you early exercised over a year ago.
Same example as above with more numbers:
In this example, 1,000 ISOs were granted and immediately early-exercised on January 1, 2024.
The first tranche of options vested per the original vest schedule on January 1, 2025.
The company was acquired on June 6, 2026 which results in a qualifying disposition for 250 shares – but not for the remaining 750 shares that had not been fully vested per the original vest schedule.
Rather, the remaining 750 shares will be subject to ordinary income taxation.
Had the employee been granted NSOs instead of ISOs, all 1,000 early-exercised shares would have been subject to long-term capital gains – a much better outcome.
What should I do if I’m granted early-exercisable ISOs instead of NSOs?
It’s time to put on your negotiating hat! If you’re planning to early-exercise your ISOs, I’d ask the company to re-issue these at NSOs. In all fairness to the company, they probably just don’t realize the implications and will want to do right by you anyways. However, if you’re not planning to early-exercise, then it may be best to keep your options as ISOs.
Feeling overwhelmed? You’re not alone. It’s why I started this business in the first place! Always feel free to reach out. I’d be happy to be a sounding board.
**This blog is for educational and informational purposes only and should not be considered investment advice**