Case Study: Early employee at unicorn saves ~$128k in taxes through early exercising
- Client previously worked in tech for 7 years
- In 2018 they joined a Series A startup as an early engineer
- They were given stock options and decided to early exercise, using a combination of cash and selling some of their public investments
- Now the company is looking at going public
- Because they exercised early, they will save ~$128k in taxes
The client started their career as a software engineer at a FAANG company then they became interested in startups. They’ve been at two different startups now and just accepted a job offer to be an early engineer at a promising Series A company.
Here’s a summary of their 2018 personal balance sheet:
A written summary of their accounts:
- Cash: checking account
- Public Assets: ~$719k total, ~$480k of which is in a 401k
- Real Estate: $1.2m house in San Francisco, $857k remaining on the mortgage, 3.5% fixed rate
- Company Equity: has worked at 3 different startups, only 1 still has private equity
- Crypto: bought Bitcoin a few years ago and has held
- Private investments: doesn’t invest in startups or venture capital funds
Problem / goal
The client has started work at their new company and received an equity package as part of their compensation. They need to develop an options strategy and execute on the strategy.
Here’s a summary of their equity grant:
In case you need a refresher, here’s what each term means.
- Type (ISO): a type of option that’s commonly granted at startups.
- Issue date: the date that your options were granted to you (typically a start date)
- Amount issued: the number of options you were given
- Strike price: the price at which you can exercise your options. This is included with your initial grant and usually doesn’t change over time.
- Early exercise allowed (Yes): early exercising is when you can exercise your options before they vest. While many companies don’t offer it, in this example the company allows employees to early exercise their options. You can read more about early exercising here.
- Option expiration policy (90 days): if you leave the company (either under your own power or because you were laid off) and you haven’t exercised your options, they will expire after a certain period (90 days here). This means that you won’t have the options anymore.
At the time, the company’s future was uncertain. Here are a few details about the company at the time:
- Revenue: $1.5m ARR
- Monthly growth: 15%
- Products: had a core product and were refining it to expand into additional markets
- Team: the client strongly believed in the CEO and it was one of the main reasons they joined
In this situation, the client could’ve taken many possible paths, but to simplify things, let’s assume that there were two options:
Option 1: Early exercise all stock options in 2018
Cost: $25,000 to exercise options
In this option, the client decides to use a combination of cash ($10k) and selling public investments from their brokerage account ($40k) to early exercise their options. They made sure to file Form 83(b) so that they received the full tax benefits.
Option 2: Exercise all stock options in 2022
Cost: $153,340.50 ($25,000 to exercise options and $128,340.50 in taxes)
In this option, the client takes no action immediately and instead decides to wait until 2022 to exercise their options. By 2022, the 409A valuation on this company has risen from $0.50 to $10.00. As a result, they end up having to pay the alternative minimum tax of $128,340.50 in addition to the exercise cost.
Results & Benefits
In this case study, the client chooses Option 1 and exercises their options.
The client’s total net worth is $2.6M. The equity from this new startup (still illiquid) is valued at $500k.
Benefit 1: Tax savings
Because the client exercised when the strike price was equal to the 409A price, they didn’t pay any taxes when they exercised. Additionally, because they’ve held the shares for over 1 year and had been granted the options over 2 years ago, they will only pay long-term capital gains when they sell their shares.
Exercising early also starts the clock for qualified small business stock (QSBS). QSBS is a tax exemption that enables taxpayers to receive tax-free gains from the sale of stock, up to the greater of (i) $10 million, or (ii) 10x their original investment. Practically, a lot of the capital gains tax that this client will have to pay if they sell could be avoided under the exemption. However, there are several requirements for QSBS, including having ownership of the shares for at least 5 years. Read more about QSBS here.
Benefit 2: Peace of mind
As they company grew, the client didn’t have to worry their options strategy as much as they would have if they hadn’t early exercised. They owned part of the company and were able to focus on building the company instead of the nitty gritty details of tax law.
Additionally, by owning all of their shares they had the flexibility to leave the company if and when they wanted to. If you leave the company, your options will expire if you don’t exercise them. The exact timeline of how quickly they expire depends on option type and company policy, but the termination window is commonly as short as 90 days. Exercising them avoids this situation.
Risk: what if the company failed?
In this case study, the client early exercised all of their options and earned benefits for doing so. However, it could’ve gone another way: the company could’ve failed. By the numbers, this is the most likely outcome, so choosing Option 1 and exercising options early was a risky decision.
If this client chose Option 1 and the company failed, they would’ve lost the $25k that they invested.
If this client chose Option 2 and the company failed, they wouldn’t have lost any money and instead could’ve kept it in cash and public investments.
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