Early exercise stock options enable employees to purchase their entire option grant before shares have vested, typically combined with an 83(b) election. This strategy can significantly reduce tax liability if the stock appreciates, but requires upfront cash payment and carries risk if shares lose value.

What is Early Exercise

Early exercise allows employees to buy unvested stock options immediately upon grant rather than waiting for shares to vest. This mechanism transforms options into restricted stock that remains subject to the company's repurchase rights until vesting completes.

Definition: Early exercise is the ability to purchase stock options before they vest, converting options into restricted stock subject to repurchase by the company if vesting requirements are not met.

Employees can exercise their entire option grant on day one of employment. The exercise price remains the strike price established at grant date, typically matching the fair market value at that time. For early-stage startups where current valuation is minimal, the spread between strike price and fair market value approaches zero.

Key timing advantages:

  • Exercise at lowest valuation - Before company growth increases stock value
  • Lock in strike price - Prevent dilution from affecting exercise cost
  • Start capital gains holding period - Immediately upon exercise
💡 Key Insight: Early exercise is most valuable at very early-stage companies where current 409A valuation equals or nearly equals the strike price, minimizing initial tax liability.

Stock acquired through early exercise carries repurchase rights. The company can buy back unvested shares at the original exercise price if the employee leaves before vesting completes. As shares vest according to the original schedule, the repurchase right lapses proportionally.

Feature Description
Trigger Event Employment termination before vesting
Repurchase Price Original exercise price paid
Vesting Impact Restrictions lapse as shares vest
Control Transfer Full ownership transfers upon complete vesting

How Early Exercise Works

Exercise and 83(b) Filing Process

Employees submit exercise paperwork and payment immediately after option grant. The company issues stock certificates marked as restricted.

Exercise process steps:

  1. Submit exercise notice - Notify company of intent to early exercise
  2. Provide payment - Pay full exercise price for all shares upfront
  3. File 83(b) election - Submit to IRS within 30 days of exercise
  4. Receive restricted stock - Company issues shares subject to repurchase
  5. Begin vesting schedule - Original 4-year vesting timeline continues

The total cost equals the number of options multiplied by the strike price. For 40,000 options at $0.10 strike price, total payment is $4,000. At early-stage companies, this strike price often represents the current fair market value, reducing immediate tax liability.

⚠️ Warning: The 83(b) election must be filed within 30 days of exercise. Missing this deadline eliminates the primary tax benefit of early exercise.

Repurchase Rights and Vesting

The company holds the right to repurchase unvested shares if employment terminates. The repurchase price equals what the employee originally paid.

Situation Vested Shares Unvested Shares
Voluntary Resignation Employee keeps Company can repurchase
Termination for Cause Employee keeps Company can repurchase
Company Acquisition Employee keeps Depends on deal terms
Vesting Complete Employee keeps all None remaining

Early exercise does not accelerate vesting. Most startup vesting follows the standard 4-year schedule with 1-year cliff: 0% vested for the first 12 months, then 25% vests, followed by monthly vesting for the remaining 36 months. As each portion vests, the company's repurchase right for those specific shares permanently lapses.

📋 Quick Summary: Repurchase rights protect company interests but don't change the employee's tax treatment - the 83(b) election has already locked in the tax basis.

Tax Benefits and 83(b) Election

How 83(b) Creates Tax Advantages

The 83(b) election enables employees to recognize the taxable value of restricted stock immediately rather than as it vests. When combined with early exercise, this creates significant tax advantages.

Definition: An 83(b) election is an IRS filing that allows employees to pay income tax on the full value of restricted stock at grant/exercise rather than at vesting, converting future appreciation to capital gains.

Without an 83(b) election, restricted stock triggers ordinary income tax as each portion vests. With an 83(b) election after early exercise, all income tax is recognized immediately. If the strike price equals current fair market value, the taxable spread is zero.

Tax recognition comparison:

Scenario Tax Event Timing Taxable Amount Tax Type
No 83(b), Standard Exercise At each vesting date FMV at vest - strike price Ordinary income
83(b) + Early Exercise At exercise date FMV at exercise - strike price Ordinary income
Future Sale (with 83(b)) At sale date Sale price - FMV at exercise Capital gains

Early exercise at $0.10 strike price with $0.10 FMV creates zero taxable income at exercise. Future appreciation becomes long-term capital gains if holding periods are met.

Example calculation:

With 83(b) election:

  • Early exercise 40,000 options at $0.10 strike price
  • FMV at exercise: $0.10
  • Ordinary income tax: 40,000 × ($0.10 - $0.10) = $0 taxable income
  • Tax owed: $0
  • All future appreciation taxed as capital gains
💡 Key Insight: The optimal early exercise scenario occurs when strike price equals fair market value, resulting in zero ordinary income tax at exercise and converting all future gains to preferential capital gains rates.

Capital Gains Treatment

All appreciation after the 83(b) election date receives capital gains treatment rather than ordinary income treatment. This typically saves 15-20 percentage points in federal tax rates.

Long-term capital gains requirements:

  • Hold stock for more than 12 months from exercise date
  • Sell after the qualifying holding period ends
  • Pay preferential capital gains rates (0%, 15%, or 20% based on income)

For incentive stock options (ISOs) with early exercise, additional requirements apply. Holding shares for 5+ years from exercise may qualify for QSBS treatment under Section 1202.

Income Level Ordinary Income Rate Long-Term Capital Gains Rate Tax Savings
$100,000 24% 15% 9 percentage points
$200,000 32% 15% 17 percentage points
$500,000+ 37% 20% 17 percentage points
🎯 Key Takeaway: Early exercise with 83(b) election shifts tax treatment from high ordinary income rates to lower capital gains rates for all post-exercise appreciation.

Key Risks and Considerations

Financial Requirements and Downside Risk

Employees must pay the full exercise price for all shares immediately. For 40,000 options at $0.50 strike price, the upfront cost is $20,000 cash - a significant commitment for early-career employees. Additional costs include ordinary income taxes if strike price is below fair market value, and 83(b) election preparation ($500-$1,500).

⚠️ Warning: Only use cash you can afford to lose completely. Startup equity is highly risky and most startups fail, making early exercise a speculative investment.

If company valuation decreases after early exercise, you've paid more than the stock is worth. The 83(b) election cannot be reversed even if stock becomes worthless. If shares become worthless, you can claim a capital loss limited to $3,000 per year against ordinary income.

Early Exercise Requirements

Not all stock option grants permit early exercise. Company policy and plan provisions must explicitly authorize this feature. Early exercise is most common at seed and Series A startups where strike prices closely match fair market value, becoming rare at later-stage companies due to higher upfront costs.

Check your stock option agreement and equity plan documents for "early exercise" or "immediate exercise" language to determine eligibility.

📋 Quick Summary: Confirm early exercise eligibility in your option agreement and equity plan documents before proceeding.

Termination Scenarios

Leaving the company before full vesting allows the company to repurchase unvested shares at the original exercise price. You recover your initial investment but gain no appreciation.

Voluntary resignation after 2.5 years (of 4-year vest):

  • 56.25% of shares have vested (keep these)
  • 43.75% remain unvested (company can repurchase)
  • You receive back the exercise price for repurchased shares
  • Vested shares retain full appreciation potential

Termination before the 1-year cliff:

  • The company can repurchase 100% of shares
  • You recover your exercise cost but receive no benefit from early exercise strategy
⚠️ Warning: If terminated before the 1-year cliff, the early exercise strategy provides no tax benefit, though you do recover your initial cash investment.

When Early Exercise Makes Sense

Early exercise provides maximum benefit at truly early-stage companies where strike price equals fair market value.

Successful outcome example:

  • Join seed-stage startup, granted 40,000 ISOs at $0.10 strike
  • Early exercise for $4,000 ($0 ordinary income tax)
  • Company acquired 5 years later at $10/share
  • Total value: $400,000 with $4,000 cost basis
  • Capital gain: $396,000 taxed at long-term rate (20%)
  • Net proceeds: $320,800
  • Tax savings vs. standard exercise: ~$63,000

Failure scenario:

  • Early exercise 40,000 options for $4,000
  • Company fails, stock becomes worthless
  • Capital loss limited to $3,000/year deduction
  • Net loss after tax benefit: ~$2,500
💡 Key Insight: Early exercise works best at truly early-stage companies where strike price equals or nearly equals FMV, providing tax benefits with manageable downside risk.

Frequently Asked Questions

What is the 83(b) filing deadline?

File within 30 days of exercise via certified mail to the IRS Service Center where you file taxes. Provide a copy to your employer and attach a copy to your tax return.

Can I early exercise options at any company?

Only if your company's plan explicitly permits it - not a standard feature. Most common at seed and Series A startups; rare at mature companies.

What happens if I leave before vesting?

The company can repurchase unvested shares at your original exercise price. You keep vested shares with full upside, but recover only your initial investment for unvested shares.

Can I reverse an 83(b) election if stock declines?

No, it's irrevocable. If shares become worthless, you can claim a capital loss limited to $3,000/year against ordinary income.