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Capital gains taxes. When the "fair market value" of the company increases away from your strike price, when you exercise your options you have to pay tax on the difference between your strike price and the fair market value. And it will be a short term capital gain so it isn't cheap. If those .20 options of your have a fair market value of 5.00 now, you will owe tax on 4.80 of capital gains. 4.80 * 100,000 is 480,000.00 and a tax rate of about 40% on that means you will owe $192,000.00 in taxes to exercises $20,000.00 in options. So you will need around $210,000.00 to get out.

And even after that you're holding a non-liquid asset which could be diluted to nothing or the company could simply fail and you can't dump the stock.

Then, simply don't exercise your options--you won't have any taxes to worry about.

As the article states, you typically have 90 days after leaving a company to exercise your options or you lose them entirely. Yes, that avoid taxes, at the risk of eliminating any potential upside.

You have a choice though. The exercise price + taxes is the price you pay for potential upside. Not willing to take that risk? Just walk away from your options and pay nothing.

If that's the truth and the employee's best guess as to the company's outcomes are that their options will either be worth nothing or the taxes will be too expensive to afford with the cash available to him, the employee should rationally value any option grant at zero. Startups may find it a little hard to recruit employees if everyone starts valuing options at zero. This isn't in anyone's interests.

That's my argument exactly. Employees should value illiquid stock options at close to (but not exactly) zero. They're assets that have potentially huge upside, but also the risk of ending up worthless, cannot be sold now, and have no guarantee that they will ever be sellable. A rational decision maker would value such an asset at close to zero.

I'd argue that it's in the employees' best interest to realistically value the equity portion of their compensation package.

*if that employee doesn't have sufficient liquidity to take the risk.

This is another case in the world where having money helps you make money. I think most people rationally understand that it often takes money to make money, but the startup scene is usually portrayed differently.

So if you don't exercise your options, then why take the pay cut and work twice as hard for a startup ? The whole thing reeks of a scam against early employees.

Exactly.

The company's valuation increases fifty-fold. Now you decide to exercise your stock options, and you pay $20,000. You have just paid $20,000 for stock that is now worth $1,000,000.

The IRS now expects you to pay tax on your $980,000 in income. However, your stock is not liquid, so you can't sell it. This is why you can need "millions" to acquire your options.

Why would you exercise a stock option to receive stock you can't sell? If you can't sell it, it's not worth $1,000,000--it's a piece of paper that might one day be worth more or less than $1,000,000.

Here's the advantages of exercising stock options and filing an 83b election as soon as you join a company:

* When the company has an IPO, you only pay the Long Term Capital Gains tax rate (20%), instead of the standard income tax rate (39.6%).

* Once your stock options have vested, you have the freedom to leave at any time without worrying about taxes or losing your options.

So you can risk tens of thousands now to potentially save hundreds of thousands later, in addition to giving you some freedom.

It's very risky. The company might fail. The company might be successful, yet never have a liquidity event (acquisition or IPO). But you only join a startup if you believe it has a good chance at success. You're risking a huge amount of time and effort, so you may as well risk a bit of cash too.

Because you'd like to do something new and if you leave you must either exercise within 90 days or lose your options.

So if you want to leave, your choices are:

1. Exercise your options, pay potentially huge taxes on it, and be left holding stock that is practically worthless because you can't sell it

OR

2. Give up your options and move on with your life

I know what I'd do.

It's not always that easy. People are not totally rational. Loss aversion is powerful. I've been in that situation. I'm actively avoiding putting myself in it again.

Fair enough, my argument relies on rational decision making.

Why work for a startup then ?

You were young and didn't realize these realties. 83b elections are not feasible since you have no savings to your name right out of school.

(Hint: this is where part of the SV age discrimination comes from)

Because your options are about to expire.

It's the AMT issue. In your example, if the company's valuation increased by 50X, the spread between the FMV and the exercise price would be $1,000,000, so you would have to pay taxes on AMT income of $980,000 - assuming AMT is 20%, that's almost $200k. It sucks =)

Of course IF you are lucky enough to have $20K sitting around, enough faith in your company the day you get your options AND your company lets you early exercise, then you can avoid this. Unfortunately, for most folks those conditions are not all met =(

The article doesn't state this well, but the additional cost comes from AMT. If you exercise your options you pay AMT on the face value of a share of common stock at time of exercise minus the exercise price (the spread). This is true regardless of whether or not those options are liquid at the time. For a unicorn, the stock has most certainly increased in value over time, which means the exercise price is a fraction (possibly a very low fraction) of the current value, and you'll be writing the IRS a much larger check than you write the company.

The only escape from this problem is an 83(b) election, which I've heard many companies say they don't allow (IANAL and am not sure what the circumstances are here). It's also the case that with an 83(b) election you are putting real money, potentially a significant amount of real money, into the company's bank account with no expectation of when that investment will become liquid. So this also has risks, but at least the AMT is on the spread, which is $0 in this case.

Virtually nobody talks about the AMT credit when discussing ISOs and the AMT trap. Everybody assumes that AMT is this horrible beast, and while it's never a good thing, folks would do very well to have an experienced professional look at their unique situation and perform the calculations because it's often not nearly as bad as suggested.

I have a 7 figure AMT credit that will likely never be eliminated in my lifetime. People in this position hopefully all have competent tax attorneys who understand the credit. The reality is that the credit isn't very meaningful to people like me (and I am pretty typical among people who work at Unicorns).

If you make a salary income around $150k/yr in California, your AMT credit no matter how large is going to be a few hundred dollars per year.

AMT credit is worthless unless your salary income is around $300k+.

AMT should not apply until you actually liquidate capital gains, but good luck getting that kind of thing passed or addressed.

Sure, $20,000 for the shares but what about the taxes you'd owe on the shares? If the value increases 50-fold, does the IRS not see that as 1,000,000 - 20,000 = $980,000 of taxable income?

You should understand the tax (particularly AMT) implications of exercising. $20k cost to exercise. $300k to Uncle Sam (given your 50x increase).

You should understand that every situation is different. Are you talking about NSOs, or ISOs? Have you factored in the minimum tax credit?

Very few articles on ISOs and AMT highlight the minimum tax credit that is applied when the amount paid under AMT exceeds what would otherwise have been paid.

You still need to pay your taxes in one year to claim it as a credit in a successive year. Uncle Sam and California don't take kindly to IOU's (nor does your credit score).

What if you exercise a little every year, triggering AMT each year? No credit for you and the credit is reduced the older it gets. Like you said, each situation is different, but most people are going to pay a boatload in taxes on this and not be able to claim it as a credit later on.

The cost of exercising does increase after a big jump in valuation because you have to pay AMT tax on the unrealized capital gains.

You're forgetting that there's much more in the cost of exercise than just the stock price. There's taxes as well.

And even just thinking about the stock price, $20,000 can be a lot of money to spend on something you can't sell.