For young startups, I always recommend allowing Early Exercise. Put simply, it's the right by employees to exercise their options before they vest. The company retains a right to repurchase those options should the employee depart before they vest.
This enables them to exercise them as soon as they're granted, which greatly reduces the tax burden in two ways:
- First, the strike price and the value of the option are the same when they're granted, which means that the spread (i.e. the difference between exercise price and value of the options exercised which the IRS considers profit for AMT) is zero. Therefore, no taxes need to be paid. I've been stung by a 5-figure AMT tax bill on exercised options that were completely illiquid—all of which would've been avoided had I exercised early.
- It starts the clock for long-term capital gains. You need to hold the actual stock for over 1 year to be taxed at capital gains rates instead of income tax rates. Federally, this can lower your tax rates from up to ~40% to ~20%. (would've been 15% pre-Obama!) In CA, for state taxes there is no distinction, so you'd still be paying income tax rates of ~10-13%
Keep in mind, if you early exercise, that you must file an 83b election with the IRS within 30 days, or the tax consequences can be severe. (If you don't, you'd be taxed on the spread at the current option value every time some of your options vest.)
Now, I think extended exercise windows are great too, and ideally option agreements would have both. I think generally, early exercise makes more sense for employees who join pre-Series-B, while extended exercise windows make more sense for later stage employees.