An Engineer’s guide to Stock Options

While I am not a lawyer, this is a cut and paste from an email from our lawyers: "83(b)s are only for restricted stock."

It is my understanding that you don't file an 83(b) for ISOs or any other type of options, only for actual restricted stock.

That is correct. The 83(b) declaration is only valid for 'restricted stock' which is stock that is granted to you rather than as an option to buy.

In those situations you acquire the 'right' to the stock over time (this is called vesting). And when you vest stock the IRS treats it like income and it gets added to your W2 as such.

The 83(b) election allows you to take the entire tax hit immediately even though you don't have the ownership rights on the stock yet. You need to come up with the tax payment but since you "own" the stock even when it vests you won't pay additional taxes, and your ownership starts the clock on long term gains (vs short term gains).

If the stock is going up an 83b can save you some money, if it is going down it makes it more complicated (you can write off up to $3,000 of "loss" per year of stock which is worth less than the 83b election price. I got to do that for just over 10 years on my dot com era 83b stock election.

Generally places like Facebook or Google will sell some of your RSUs as they vest to cover the tax hit so its pretty invisible to you.

Everyone gets diluted when a company raises more money: founders, employees, and previous investors. Investors usually have ‘prorata rights’ which mean they are allowed to invest additional money at the new valuation to maintain their given percentage ownership of the company.

Founders generally have the same class of stock as employees (common stock), and so are in the same boat.

Investors have preferred shares. Preferred shares have a few special properties, but the most important is ‘liquidation preference’, meaning they’re first in line to get their money out if things go wrong. Sometimes investors have a right to a multiple on their money back: twice their money would be a 2x liquidation preference.

One thing to ask about in the case of a company that has raised money on convertible notes. Since they haven’t actually sold equity, but only debt which will later convert equity, it’s worth asking if a given stake is before or after those notes convert.

Generally, if things are going well, dilution isn’t worth worrying about. In any case, the founder will be just as diluted as any employees, so their interests are aligned.

If your stock option plan allows you to "early exercise" (exercise before the options vest--this gives you restricted shares that vest on the same schedule as the options you exercised) then you can file an 83(b) for those restricted shares.

Edit: I should add that this only matters for AMT purposes. If you early-exercise ISOs then the 83(b) election doesn't change anything for regular income tax, but does effectively accelerate your AMT income.

I've "pre-exercised" before, with a meaning different from what's depicted here in the article.

In the "pre-exercise", I was able to exercise the stock before I'd vested in it, with the understanding, of course, that the company would buy back my unvested shares at the exercise price if I left the company before vesting all the options.

The disadvantage, of course, is that you pay for your stock up front, and will lose all or most of the money if the company doesn't pan out.

There are several advantages ...

Advantage: the price you exercise at is near the fair-market value of the Common Shares you purchase (and haven't yet vested in), so there's no immediate gain and so no immediate short-term gain tax consequences. You need to make sure to file an 83(b) form so you're telling the IRS you're paying your $0 tax up front, rather than monthly as your stock vests. (The disadvantage with the latter is that the difference between what you paid and what your stock is worth as it vests could be huge, and there's no way to liquidate your stock to pay that tax.) (There's also something about AMT in here, I'm kind of fuzzy, but I think consequences can be the same.)

Advantage: your long-term capital gains clock starts ticking the day you buy the stock, even though you bought before any of it vested. When, three years down the road, you can liquidate your stock in that acquisition or IPO or secondary-market sale, you already purchased your stock three years ago, and pay only long-term gains. Otherwise, you'd buy the stock and sell on the same day, with the gains considered as short-term-gains/income rather than long-term gains.

My personal outcome with pre-exercised stock: worked out OK twice, lost all my pre-exercise once, but overall I came out ahead on taxes even with the loss. YMMV.

What the article says is "pre-exercise" is just an "exercise" -- you vested the stock, you have every right to purchase it even though the company's stock isn't yet liquid. The problem, of course, is that you may have a huge gain and no way to pay for taxes on that gain.

(Edit: note about AMT, clarification.)