You work at a genomics start-up and are granted 10,000 stock options with a strike price of $0.20 (at private companies, the strike price is determined by a 409A valuation).

Three years later, the company is wildly successful and IPOs at $20.20, for a gain of $20 per share.

Your options are now worth $200,000: 10,000 shares x the difference between the IPO price ($20.20) and the strike price ($0.20).

For simplicity, let’s assume that, at the IPO, all your unvested shares become vested and all your shares are exercised and sold (post lock-up). Since you waited until the IPO to exercise and sell, here’s the tax impact (assuming Federal and California tax rates that keep the math simple):

$200,000 x 35% Fed tax = $70K.

$200,000 x 10% CA tax = $20K.

Total tax = $90K.

Basically, the $200,000 gain is taxed like a paycheck.

If, however, your stock option plan allowed you to ‘early exercise’, you could exercise the option on the date it’s granted (before it vests).

To do this, right after the grant date, you would write a check to your employer for the number of shares (10,000) x the strike price ($0.20) = $2,000. You would also immediately file an 83b election with the IRS (in essence, this election helps you pay less tax). 

Since you exercised your options on the grant date, you now own 10,000 shares worth $0.20 each = $2,000. Three years later at the IPO, you have the same $200K gain:

$20.20 IPO price minus $0.20 strike price = $20 per share gain x 10,000 shares = $200,000 gain.

But, instead of being taxed like a paycheck, the gain is now taxed at long-term capital gain rates:

$200,000 x 18.8% Fed Tax (15% long-term rate + 3.8% medicare surtax) = ~$38K (vs $70K from above)

$200,000 x 10% CA Tax = $20K (sorry, no tax break here but ahh that CA sun!)

Total tax = ~$58K vs $90K, a savings of ~$32K.

Note: this example assumes your adjusted gross income for the year, including the $200K capital gain, is less than $500K (married filing joint).

Of course, there’s no free lunch so what’s the downside? If you exercise early and the company closes shop, you’re out the $2K you spent to buy the stock. Ouch. As always, carefully weigh the tradeoffs.

Hope this helps!

Disclaimer: For information purposes only and should not be interpreted as legal, tax or financial advice. Always consult your CPA/tax advisor/attorney (or reach out to us;) to discuss your specific situation. Past performance is no guarantee of future results.