Should a company allow early exercise of stock options?
Takeaway: Allowing early exercise is a powerful, pro-employee recruiting tool that provides significant potential tax benefits, but it comes at the cost of increased administrative complexity and a real financial risk to the company.
The decision of whether to allow employees to "early exercise" their stock options is a strategic policy choice for a startup's board of directors. It is not a legal requirement, but rather a feature that a company can choose to offer to make its equity grants more attractive. While hugely beneficial for employees, it introduces a new layer of administrative work and a specific financial risk for the company. Weighing these trade-offs is key.
The "Pros": Why Companies Offer Early Exercise
The primary reason to offer early exercise is to compete for and retain top-tier talent. For a sophisticated candidate, the ability to early exercise is a major perk.
A Powerful Recruiting Advantage: It signals that the company is founder-friendly and employee-centric, and that it is willing to provide its team with the tools to achieve the best possible personal tax outcomes.
Significant Employee Tax Benefits: As we've discussed, early exercise allows an employee to start their long-term capital gains and, most importantly, their five-year QSBS holding period clocks years sooner than they otherwise could. This can translate into millions of dollars in tax savings for the employee upon a successful exit.
Aligns for the Long Term: By enabling employees to start their long-term holding clocks, you are creating a powerful incentive for them to think like long-term owners of the business.
The "Cons": The Company's Burden and Risk
Administrative Complexity: This is the most significant operational burden. When an employee early exercises, the company is no longer just tracking a simple option grant. It is now managing actual shares of restricted stock. This means:
Tracking the company's repurchase right on the unvested portion of the shares.
Meticulously tracking the 83(b) election filings for every employee who early exercises.
Handling the administrative process of repurchasing unvested shares if an employee leaves.
The Financial Risk of Repurchasing Shares: This is a real, though often small, financial risk for the company. The company's repurchase right is typically at the original exercise price. If an employee early exercises at $0.10 per share, and the company's 409A valuation later drops to $0.05 per share before that employee leaves, the company is contractually obligated to buy back the unvested shares at the higher $0.10 price, realizing a direct financial loss on the transaction.
Potential for Employee Confusion: Early exercise requires an employee to make an immediate cash outlay to purchase the shares and to correctly file an 83(b) election. This can be confusing for less experienced employees and requires the company to invest time in educating its team on the risks and requirements.
For many technology companies, the benefits of offering early exercise as a tool for attracting elite talent are seen as outweighing the administrative costs. However, it must be a deliberate decision made by the board with a full understanding of the complexities involved.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.