What are Early Exercisable Stock Options?
Takeaway: An early exercisable stock option is a powerful but complex feature that allows an employee to purchase unvested shares immediately, but the tax benefits vary dramatically between NSOs and ISOs and require careful analysis.
A standard stock option has a clear rule: you can only exercise the portion of your option that has vested. However, some companies offer a special feature that changes this dynamic: the early exercise provision. An early exercisable option is not a different type of option; it is a feature that a company can add to a standard ISO or NSO, giving the holder the right to purchase all of their shares immediately after the grant date, before those shares have vested.
How Does Early Exercise Work?
When you early exercise, you pay the full exercise price upfront and become the legal owner of all your shares. However, those shares are still subject to the original vesting schedule.
The Company's Repurchase Right: The shares you purchase are "restricted." If you leave the company before your original vesting schedule is complete, the company has the right to repurchase your unvested shares back from you, typically at the price you originally paid for them. As you continue to work and your shares vest, the company's repurchase right on that portion of the shares lapses.
The Intended Tax Benefits (and a Major Trap)
The primary motivation for early exercise is to achieve a better tax outcome by starting the long-term capital gains and QSBS holding period clocks as early as possible. However, the actual benefits differ dramatically depending on the type of option.
For Non-qualified Stock Options (NSOs): Early exercise works as intended. If you exercise immediately upon grant when the stock's fair market value equals the exercise price, and you file a timely 83(b) election, there is no income tax due at exercise. The clock for both long-term capital gains and the five-year QSBS holding period begins on the date of exercise. This is the ideal tax outcome.
For Incentive Stock Options (ISOs): A Critical Trap. Contrary to popular belief, early exercising an ISO does not start the capital gains holding period upon exercise. The tax code dictates that for restricted stock received from an ISO exercise, the capital gains holding period only begins when the stock vests. This completely negates the primary tax benefit of early exercise. Furthermore, making an entire ISO grant early exercisable can cause more of the award to exceed the annual $100,000 ISO limit, converting a larger portion into NSOs by default.
The Mandatory 83(b) Election
For any early exercise of either an ISO or an NSO, the employee must file an 83(b) election with the IRS within 30 days. Failure to do so results in a tax catastrophe, where the employee is taxed on the value of their shares as they vest in the future, defeating the entire purpose of the early exercise.
Given the significant tax complexities and the traps associated with ISOs, the decision to offer an early exercise program requires careful strategic consideration by the company and its board.
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.