Why early exercise matters more in today's venture funding climate

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If your company allows early exercise, it makes things really interesting as an employee with a chunk of options. The effect is that you can make the decision as early as day 1 (well, really, whenever your option grant is approved) of your employment to exercise your options and get timers started on capital gains and qualified small business stock treatment. There’s pros and cons, and risks and advantages. In today’s fundraising climate, more than ever before, I believe that early exercise is an important consideration for employees and employers.

Why wouldn’t a company want to offer early exercise?

The first question to really answer is: why would a company ever not offer early exercise? I think the answer has changed over time, personally. Early exercise necessitates a whole bunch of additional processes that the company has to have in place, because if you screw up the early exercise process (on either the company side or the employee side), it can create big hard-to-repair boo-boos.

When you exercise early, you effectively decide to buy a bunch of shares of stock before you actually own them. You issue a check to the company, the company says “Ok, you can own the stock, but we’re going to adjust the language of your vesting contract, and force you to allow us to repurchase your stock if you leave before the shares would have been vested.” Then you turn around to the IRS and declare “I am purchasing this stock, and you should tax me on its value now.” The really important change to your equity is how it vests.

  • In standard options contracts, you earn (aka vest) the right to purchase corporate stock at a set strike price over the course of your vesting schedule (usually this also includes a 12-month 25% cliff, before which you’ve vested nothing)

  • When you early exercise, there’s still a 25% cliff at 12 months, but instead of vesting the right to exercise, the company forfeits (over the vesting schedule)the right to repurchase the vested corporate stock at the strike price

In each case, this vesting, or forfeiting of repurchase rights happens over a vesting schedule, typically four years. That’s why when you early-exercise, your vesting is sometimes referred to as reverse vesting. This leads us to reason number one that companies wouldn’t want to offer early exercise:

Reason 1: Lawyer Fees. Since early exercising involves changes to your equity contract, in the form of adjustments to how vesting works, lawyers have to be involved. And when lawyers are involved, money is involved. Understandably, a company may not want to spend money on those lawyer fees, so may choose to disallow early exercise for that reason.

Reason 2: Added Exercise Complexity. There’s also the added wrinkle that, in the case of early exercise, employees will need to file paperwork with the IRS (specifically a form called an 83(b) election), which notifies the IRS that you are purchasing shares that you don’t officially own yet, but you want to recognize the income on them. You have to file that form within 30 days of the purchase, so timeliness is critical. If the company feels like the burden is on them to ensure that everything goes correctly, it may feel simpler just to disallow early exercise entirely.

Reason 3: Added Offboarding Complexity. Not only does early exercise make exercising more complex, but it actually makes employees leaving the company more complex, as well. If an employee early-exercises four years worth of equity on day one, but leaves after two years, the changes in the vesting schedule will obligate the employee to sell back the unvested two years of stock at the same price that they bought it for. Now, technically, the company doesn’t have to repurchase the stock, but in almost all cases they will. This means that the company has to make stock certificate and cap table adjustments, as well as writing a check to the employee when they leave. More lawyers, more fees, less fun for the finance team.

Reason 4: Alignment of Incentives. At the end of the day, your company wants to retain you as an employee, and issuing stock options is one way to do that. If you can’t afford to exercise your stock (or can’t afford the tax burden associated with exercising your stock), that’s actually the company’s ideal situation. You either work your butt off to propel the business to an exit or liquidity event where you can finally realize the fruits of your labors, or you leave, can’t (or choose not) to exercise your stock, and your unexercised options are absorbed back into the pool of available options for new hires. This is kind of an intensely cynical viewpoint, but it’s not untrue.

Whatever, Natty, why do you even care?

Well, if you haven’t noticed through my ramblings on the internets, I am an employee, and I think employee thoughts, and I care about employees having opportunities to make the best possible financial decisions for themselves.

However, that’s not actually why I care. Why I actually care about this, and the real case, in my mind, for offering early exercise, is that the venture funding market is accelerating at obscene rates. 

Once upon a time, Justin Timberlake told me that a billion dollars was way cooler than a million dollars, but nowadays, it feels like a billion is the new million, and unless you’re in the 11-figure club (side note: Axios is now suggesting we should stop focusing on unicorns because there’s too damn many, and spend more of our time salivating over $12B+ dragons, who eat the damn unicorns for breakfast), you just ain’t cool. And companies are getting there fast.

As I was laying in bed mindlessly scrolling through LinkedIn the other evening, I happened across a post about Snyk’s new $8.5B valuation after a $530M raise. For funsies, I figured I’d look up their valuations historically, and found this absolutely batshit-insane growth curve:

Snyk went from $550M in August 2019 to $8.5B in September 2021. They 15x’d in 2 years. Holy crap. Now that’s not to say this is a bad thing. Anything but. However, what should concern employees at companies that experience growth curves like this is not the valuations, but the pace of funding.

If your company is stashing cash like there’s no tomorrow, or if you ever hear the words “we didn’t need this money” or “we haven’t even touched our last round” or “investors were throwing this at us,” it should raise some yellow (not red) flags. In almost all cases, the blistering pace of funding benefits two parties: founders and investors. Not employees. 

How fast-paced funding hurts employees

There’s a lot of reasons for a company to want to continue raising money. Having a huge war chest is important if all of your competitors have similar armaments. Money is historically cheap, and crossover funds like Tiger Global (who uncoincidentally led Snyk’s round) are offering ridiculously cheap, fast financing, with extraordinarily founder-friendly terms, and it’s forcing the rest of the VC community to follow suit to stay competitive. I totally get it, and if I were in a founder’s shoes, I’d probably be doing the same damn thing.

But when you think about how this plays out, once you get to the big rounds (usually C and beyond), the money isn’t all going into the corporate coffers. Snyk’s $530M round actually breaks out into two tranches: $300M of funding that was new stock issued by the company and sold to new and existing investors, and a $230M secondary stock sale. So, in reality, more than 40% of the announced funding was actually existing investors selling their stock to other investors and taking profits. That’s an enormous secondary, so I have to hope that some of that was employee participation, but in many situations, a lot of that money goes into founder pockets, and very little into employee’s. 

The other major dynamic in these fast-follow rounds is that VCs are incentivized to jack up prices further and further, in order to make their fund performance look good. At the end of the day, their funds are evaluated based on how much capital is returned to investors, but when they’re out fundraising for new funds mid-deployment, the numbers you actually have to look at center around things like internal rate of return. Huge fundraising rounds make that IRR sparkle. (And in case you’re not familiar with IRR, it’s basically, this is a measurement of how much of a return the fund is generating for investors annually, but hinges on calculations using current valuations of still-private companies, which may or may not ever be realized in the public markets). On the bright side, a lot of these companies are actually going public, and seeing massive valuations supported by the public markets, so either the economy is just fucking booming, or maybe we’re headed mindlessly towards another 2001 bubble burst.

Where this starts to cause problems for employees is when it comes to taxes at option exercise time. Remember that when you exercise your options, the IRS cares about two numbers: your strike price (which is how much you pay), and what the current fair market value of your equity is (which is what the IRS thinks your stock is worth). Then they tax you on the difference in that tax year. Sort of. The reality is slightly more complex, because if you hold NSOs, that statement is actually correct, and you’ll pay income tax on those gains, even though you probably can’t sell your stock. If you hold ISOs, you won’t necessarily pay taxes, but what will happen is that the IRS will treat those gains as contributing to your AMT liability in that tax year. If you owe more in AMT than in regular income tax, you get to pay the AMT amount.

The net of it is that the more your company’s stock appreciates value, the more likely it is that you’ll end up owing AMT, and AMT can be a big hit. In a case like Snyk’s, no matter when you start, you’re basically guaranteed to see one or two rounds of funding before you vest the first 25% of your equity grant, and in Snyk’s case, that means the FMV is likely to have increased about 4x by the time you can exercise. 

The other major downside for employees is that this fast-paced funding near-guarantees that only the earliest of early employees will be able to take advantage of the massive tax windfall that is qualified small business stock. Qualified small business stock, held for five years, has zero federal tax liability. Startup equity generally qualifies for this tax treatment, but only while the company has less than $50M in assets. Usually, that barrier gets breached the first time the company raises more than $50M in a single funding round. In Snyk’s case, that came during the B round in August 2019. For much of the last decade, the C round was usually the cutoff point for most companies. Now that cutoff is frequently creeping forward to the B as rounds get larger. The key bit here is that what matters is that you exercise your stock before that point, and for employees coming in shortly before rounds that push past that limit, they’ve got no shot.

Allowing early exercise is employee-friendly

Early exercise is a very effective way to be employee-friendly, because it gives employees optionality and opportunity to optimize taxes. The critical thing to understand is that on the day that your grant is issued, the strike price, and the fair market value are the same. Which means, if you exercise your options on that day, you have zero tax liability in the eyes of the IRS, regardless of whether you hold NSOs or ISOs. For high-flyer companies with VCs banging down their door and jamming terms sheets in the mail slot, this can be really advantageous for employees.  

Yes, it adds complexity to the decision-making process of whether and when to exercise options, but the core decision isn’t really that much different than deciding to exercise vested options in general (there are nuances, for sure, but the core question remains: do you think this stock will be worth more in the future and that there will be a market in which to sell it?). 

That said, there are some additional details to keep in consideration when deciding whether or not to early-exercise. The most important is the scenario where your stock goes to $0. One non-obvious nuance of using an 83(b) to recognize early-exercised income is that capital losses cannot be deducted from your tax return. This actually happened to me with one of my earlier employers. I’d early-exercised about a year and a half of stock, left before it was fully vested, received a check for the stock that I had to sell back, but then sat patiently waiting for the company to shut down (which happened a couple years later), excited about reclaiming those losses. When I went to go chat with my accountant, I received the unfortunate news that they couldn’t be claimed, due to the 83(b). C’est la vie. Important to know.

Additionally, now that basically everybody just uses Carta, and Carta can handle early exercise seamlessly in the UX, and goes even further and will actually generate the 83(b) form for you, the process to early exercise is surprisingly easy from an employee point-of-view.

The other thing that is starting to become more prevalent (and which I think is an incredibly positive development) is that secondary sales and internal tender offers are starting to become more common. Typically, the way these work is that employees, who have been with the company for a fairly long period of time, are given the option to sell some portion of their vested equity during a funding round. As I mentioned with the recent Snyk round, a substantial portion of the final number that the company advertises was actually a secondary sale, which could be founders taking money off the table, an early investor wanting to recognize gains, or potentially employees having the opportunity to realize some of the fruits of their labors. It’s impossible to know exactly which of those scenarios played out, but these secondaries happen often, and present an opportunity to help resolve the tax burden that employees might otherwise face. While a company might want their handcuffs to be very, very golden, I tend to prefer a more bronze sheen.

Ask your company what they allow

As with much of my writing around equity compensation, the story remains the same: equity is compensation, and if you never manage to realize the value of that equity, it doesn’t serve very effectively as compensation. Make a point to ask your company if they offer things like early exercise, or have allowed employees to participate in secondary sales in the past. It’s useful information to have, and to be aware of. It would likely be foolish to turn down a job because they don’t offer these things, but if they do, it’s definitely a benefit worth keeping in mind for the future.

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