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Comment by redshirtrob | Hacker News Reader

Sam Altman has commented on this before. Among other things, he advocates for much longer (10 years) exercise periods for equity grants.[0]

He also discusses the need for a change in tax treatment by the IRS. One of the fundamental issues is how options are taxed. Should you exercise an option, you will need to pay taxes on the spread (delta of strike price and current FMV, i.e. latest 409A valuation).

In many cases, the spread is so small or nonexistent, that the tax bill is irrelevant. But, in a few cases it's so large that most people can't possibly raise the capital to cover the tax bill.

I think the fundamental issue is the definition of FMV. When there's no public market, and employees are covenanting away any rights to sell their equity on secondary markets, is there really a fair market? I would say no.

[0] http://blog.samaltman.com/employee-equity

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"Should you exercise an option, you will need to pay taxes on the spread (delta of strike price and current FMV, i.e. latest 409A valuation)."

This isn't really true with ISOs (hence the point of them). You may get an AMT gain which is ugly, but you don't owe regular taxes on the spread unlike Non-Quals where you would.

TL;DR Talk to your CPA.

Yes, you're absolutely correct. That's a bad job on my part.

ISOs have a chance of pushing you into AMT land. If you exercise ISOs, and the FMV is different than the exercise price, then you should consult with a CPA to find out if you have a tax liability.

When I was in this situation I had a CPA project my taxes for the current year. It turned out that my taxes under the traditional system were more than under AMT, so I didn't have to worry. But this easily could not be the case if the spread is sufficiently large.

If the spread is nonexistent, why exercise at all? Why not just dump your money in an index fund?

I early exercised at Twilio when the spread was pretty small.

The key is that you pay taxes on that spread. If you're early enough - I was roughly #25 - and do it early in your tenure, then you only have to come up with the cash to buy the shares and a minor tax bill. If I had waited until I left to execute, the spread would have been 12-15x. I know a few people who stayed 4 years to fully vest and then executed. I don't know detailed numbers but it sounded painful.

If/when Twilio eventually IPOs, then the ROI will be far better than any index fund.

(I don't know anything about the "if/when" as I haven't been inside in over 2 years.)

Okay; I don't know anything about Twilio in particular, but in the usual non-founder startup employee scenario, where you are busting your balls working crazy hours for less than you could get at a real company, you are already assuming a risk in the form of opportunity cost and job insecurity in exchange for equity; you would triple down on this risk by dumping your savings (or borrowings) into illiquid company stock at zero or nearly-zero discount?

How do you know there will ever be a spread? If your startup fails, your shares are worthless. Or better yet, your shares are diluted out of most of their value by several subsequent rounds of private equity, which generally you have no control over whatsoever, but which will certainly go to enrich the founders. Resulting in even more direct transfer of wealth of your investment, to the founders and venture capitalists.

I'm having trouble understanding why any startup employee would do this, as opposed to exercising stock options when they actually have value and ideally some liquidity. Yeah you have to pay taxes, but that's because you came out ahead.

I don't see anything other than a massive gamble. You've already staked enough of your future on one speculative start-up as an employee; why would you then put a big chunk of your own money at risk? An index fund has reliable long-term returns.

In my particular case, I had worked in the telecomm industry before and had a good understanding of the alternatives and felt that I understood where things were going and my prediction - still yet to be proven - was that they would win.

But you are right, it is yet another risk. At Twilio, the pay was awful but I felt the longer term risk/reward was worth it.

If I was with $startup and the strike price was $texas-sized, I wouldn't do it while the shares were still illiquid because executing would be so much.

Still sounds like an all-around terrible deal to me. But best of luck and hope you see some kind of payoff.

I early exercised my CloudFlare stock as soon as I got it. As a result, I had 0 taxable gain at that point, and if the company eventually exits, my gains will be long term capital gains, AND they will be gains in whatever state I'm resident in at the time (exceedingly unlikely to be California -- Washington, for instance, has 0% income tax, no tax on capital gains, and no AMT, plus (outside Seattle) I can afford to buy a house.)

I wonder how many Uber employees asked for early exercise and got it in their offer letters. It is definitely not standard practice AFAIK.

At some companies it is in the standard offer letter. Unless you are coming in very senior or very early (or both, really) you are unlikely to get a modified option grant, other than just number of shares negotiations.

IMO the gold standard here is to issue actual founder shares as long as possible (up to and possibly past series a) and then to do options with early exercise and extended validity, and of course complete transparency on all the numbers.

I also like this:

http://blog.detour.com/introducing-progressive-equity/

Early exercise for the vast majority then is something you have to know to ask for in addition to number of shares.

So that you can get restricted stock in the startup you worked at for no out of pocket expense...?

How do I exercise a stock option with no out of pocket expense? Not restricted stock or restricted stock units.

If I exercise an option with no spread, I am paying (at least) as much as it is presently valued.

Because you may have the belief that the shares will grow much faster than an index fund.

It may be that a company has done very well but hasn't raised more money to bump up the present market value of the stock. In this case you would want to exercise early so that the clock starts for capital gains in the event of liquidity.

Thanks. That was a great post. Hopefully, his proposed solutions gain traction.

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