By Fernando Berrocal

Allowing employees to execute stock options early reduces their tax liability and increases the return on common stockholder ownership for brand-new startups. Allowing early execution of stock options as part of a new organization's share acquisition agreement has no disadvantages. Early exercise allows employees and founders to essentially purchase common stock under the terms of various types of equity option packages before they are fully vested, effectively converting those options into real shares that can now mature and be taxed as long-term gains when sold in the future.

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They can't be sold or given away until they've vested, and they don't provide you any voting rights until they've vested. Of course, there is a tax liability associated with early exercise, but if done appropriately, early exercise might allow an employee to pay closer to 20% rather than the 50% tax they might face if their options are exercised at the time of vesting. Some might argue against allowing early exercise; however, these objections are mostly based on poorly implemented early exercise techniques. If shares are properly valued, there should be no outrageous tax liability at the time of exercise if you have a thorough understanding of employee stock options and a solid equity plan.

Today's average startup compensation package should include material to educate your staff on the fundamentals of early exercise so they can take advantage of what it has to offer and make their own informed decisions.

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ISOs or Restricted Stocks?

Restricted Stock Units (RSUs) may be issued to founders and employees in a later stage business, but in most early-stage organizations, equity grants are provided in the form of Stock Options, which give employees the right to buy business shares at a predetermined price.  In most situations, these options will be Incentive Stock Options (ISOs) or Restricted Stocks (also known as Restricted Shares), with a vesting schedule dictating when the holders can exercise the options and purchase shares. When options vest, the exercise price (or strike price) can be used to purchase stock at a predetermined price. The business may repurchase unvested stock if an employee leaves before their stock options vest.

Taxation:

Since the stock option grant price for Qualified ISOs must be equal to or less than the FMV at the time of the grant, they are often relatively inexpensive to exercise in early-stage businesses. If you enable your employee's early exercise, they will only be responsible for Alternative Minimum Tax (AMT) on the spread between the exercise price and Fair Market Value (FMV), which will in most cases be zero.

If your employees want to use their ISOs early, they must make an 83b election within 30 days of the grant date to qualify for preferential tax treatment. ISOs that have been exercised early are taxable at the long-term capital gains rate if they have been held for more than two years from the date of grant and one year from the date of exercise. ISOs will otherwise be taxed as ordinary income. Any ISO shares issued beyond $100,000 in a given year will immediately convert to a separate class of stock, Non-Qualified Stock Option (NSOs), with differing tax requirements.

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Restricted Stocks are taxed similarly, with the exception that they don't need to be held for more than one year to be eligible for long-term capital gains taxes if exercised early. Keep in mind that when the number of stocks awarded increases, the disparity can widen dramatically. Add a zero or two to the dollar numbers above to get a more accurate depiction of the tax situation for certain early employees of successful businesses in the United States.

In Conclusion:

• The majority of early-stage businesses prefer to compensate staff using ISOs and Restricted Stocks.
• An 83(b) election is available for both ISOs and Restricted Stocks, which reduces the immediate tax burden.
• Any shares awarded over $100,000 in a calendar year are automatically classified as NSO.
• You must retain ISOs at least 2 years from the date of grant to qualify for taxation as a capital gain. Restricted Stocks are only allowed to be held for one year.

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