I use stock vesting to refer to both traditional options vesting agreements and the buy-back restrictions on granted stock. In practice the two approaches generally serve the same purpose: to grant stock rights to an employee over time.

What is an IRS Section 83B Election?

The Section 83B election allows employees to change the tax treatment of a restricted stock grant. Normally, employees pay regular income tax when the stock vests (the restrictions lapse) and no tax when the restricted stock is granted.

The 83B election allows employees to pay income tax on the initial grant instead of paying tax when the stock vests. More specifically, they pay tax on the difference between the amount they paid and the Fair Market Value (FMV) of the stock.

Since the FMV of a brand new enterprise is generally close to zero, most founders purchase their stock at FMV. If the founders file an 83B, they end up paying no tax at purchase and no tax when the stock vests. They will only need to pay capital gains tax when the stock is sold.

The 83B election only applies to restricted stock – it only deals with the recognition of income on stock that has restrictions that lapse.

Let’s use an example to illustrate the effect of making (or not making) the election. We’ll consider a founder that is subject to a 4 year annual vesting schedule:

At formation, the company stock is determined to have a FMV of $0.001 per share and he is granted 100,000 shares. The firm grows and the FMV increases to $.10 in Y1, $1.00 in Y2, $10 in Y3, $100 in Y4 (nice growth curve). Assume a 40% regular income tax.

Initial Stock Purchase: $100
Value of stock that vests in Y1: $2,500
Value of stock that vests in Y2: $25,000
Value of stock that vests in Y3: $250,000
Value of stock that vests in Y4: $2,500,000

83b election filed
Taxes Due at Purchase: $0
Taxes Due at Vesting Intervals: $0
At the end of the 4 years, the founder owns all of his stock outright and has paid no taxes on it. Should he sell the stock, he would be subject to long-term capital gains taxes.

No election made
Taxes Due at Purchase: $0
Taxes Due at Vesting Intervals: Y1: $1000, Y2: $10,000, Y3: $100,000, Y4: $1,000,000
Total taxes paid: $1,111,000

And these taxes had to be paid before the company ever had a liquidating event (the founder never received cash for his stock).

Even worse, if the company collapses in Y5 the founder will have paid over $1M in taxes and never received any cash for his stock.

When do you need to make an 83B Election?

Within 30 days of assuming stock ownership. This rule is notoriously inflexible. The election form must be sent to the IRS within 30 days of the grant.

83B applied to startups

The 83B is typically relevant in two scenarios:

1. Restricted stock agreements for founders. The most common scenario is the restricted stock agreements of founders. Founders should usually draft and sign restricted stock agreements at the same time that they purchase their initial shares.

   A common scenario is one where founders don’t draft vesting agreements when they form the company. Some time later, the company takes investment and the investors require that the founders accept restrictions on their existing stock.
   Since the stock in question was granted more than 30-days ago, filing an 83b might not be an option.

   I’ve received distinctly opposing views from lawyers on this scenario, and a recent ruling (Revenue Ruling 2007-49) by the IRS provides some, but not necessarily full guidance.

   Creating stock vesting agreements after the 30-day 83B window is tricky and can require new stock grants that dilute the initial holdings. Altering existing vesting agreements is much more straightforward and is directly addressed by the IRS ruling mentioned above (and typically allows the original 83b filing to remain in effect).

   In my opinion, founders should always draft vesting agreements when the company is incorporated (for a multitude of reasons). This has an important benefit of giving them the opportunity to file their 83b election within the 30-day window. This significantly lowers the risk that they find themselves owing tax as shares vest if they are required to accept vesting agreements in the future.

2. Early option exercise plans. Some option plans allow employees to exercise their options prior to vesting. This provides the employees the tax advantage of starting the clock on long-term capital gains early. Once the options are exercised, they typically become subject to a stock restriction agreement and the employees would need to file an 83B after they exercise.

How to make an 83B election
The IRS doesn’t provide a form for the 83B election, but the process is straightforward. From IRS publication 525:

How to make the choice. You make the choice by filing a written statement with the Internal Revenue Service Center where you file your return. You must file this statement no later than 30 days after the date the property was transferred. A copy of the statement must be attached to your tax return for the year the property was transferred. You also must give a copy of this statement to the person for whom you performed the services and, if someone other than you received the property, to that person.

You must sign the statement and indicate on it that you are making the choice under section 83(b) of the Internal Revenue Code. The statement must contain all of the following information.

• Your name, address, and taxpayer identification number.
• A description of each property for which you are making the choice.
• The date or dates on which the property was transferred and the tax year for which you are making the choice.
• The nature of any restrictions on the property.
• The fair market value at the time of transfer (ignoring restrictions except those that will never lapse) of each property for which you are making the choice.
• Any amount that you paid for the property.
• A statement that you have provided copies to the appropriate persons.

The form we used to file our 83B elections at BrandVerity is here. Most lawyers will recommend that this notice be sent via certified mail.

Disclaimer: I am not a lawyer, tax accountant or otherwise qualified to dispense with legal and/or tax advice. You should always consult with a qualified professional before making decisions regarding Section 83b and/or your stock plans.

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This post depends heavily on understanding the difference between ISOs and NSOs.

Exercising Stock Options

Stock options can be exercised as soon as they have vested. This always means an out-of-pocket expense by the employee to purchase the options. They are typically exercised when the company is sold or goes public. However there are situations where an employee would exercise the option before there is a buyer:

• The option would expire. The most common reason that an option would expire is because you are leaving the company. ISOs must be exercised 90 days after the employee has left the company and many NSO agreements have similar clauses. Options also expire if they haven’t been exercised within the term of the agreement (typically 10 years).
• Tax advantages. ISOs may be treated as long-term capital gains if the stock is held for a year. If you are certain the company has an exit in the near future it can be advantageous to exercise an ISO option early and start the holding period for the stock. NSOs don’t provide the same opportunity.
• There is a buyer for the stock. ISO options can’t be transferred, so if there is a buyer for the common stock the employee may have an opportunity to exercise the option and sell the stock. This is becoming increasingly common at successful still-private companies within Silicon Valley. Investors want the founders to be focused on growing the company not on a near-term exit, so investors will purchase some common stock from the founders. Although this is becoming increasingly common, it doesn’t impact many people and is only used in rare circumstances.

Early Exercise Plans are option plans where the options are granted in full at the start of the period, and vesting is handled by an expiring right to repurchase exercised shares. These are almost always ISO plans. The goal is to provide employees with the opportunity to purchase their stock early so that they can hold it for the year necessary for short-term capital gains treatment.

Early Exercise Plans also have a downside if the fair market value of the grant exceeds $100K. The IRS allows an individual to receive $100K of ISO options a year. Any amount above $100K gets treated as an NSO. You could be granted $400K in options under a standard 4yr vesting plan and all the options would be treated as ISOs because you’d technically receive 1/4 of the grant each year. If that same plan was an early exercise plan, you’d really only have $100K in ISOs - the rest would be treated by the IRS as NSOs.

I’ve also seen situations where the company will give a loan (typically to key executives) to allow them to exercise their options early. In some instances this loan may be forgiven by the company. I believe this is more common at established companies than startups but it does happen from time to time.

Should you exercise your options?

Obviously, if your company is about to get acquired (or go under), the decision is much more straightforward. I’m going to assume that your startup’s fate hasn’t been determined.

The first thing you should recognize is that unless there is a buyer for your stock, it has no value. Go read Dick Costolo’s great post on evaluating employee options.

Here is a super-simplified timeline / decision hierarchy:

1. Investors decide if they should convert their preferred shares to common.
2. Common stock holders decide if they should exercise their options.
3. The proceeds are first distributed to the preferred shareholders up to their liquidation preferences. For example, if they invested $5M with a 2x liquidation preference, the preferred shareholders would receive the first $10M of any liquidation if they chose not to convert to common stock.
4. The remaining proceeds are then distributed ratably to the common shareholders (unless the preferred stock is ‘participating preferred’. In this case, the preferred share holders are treated ratably like the common shareholders).

Simplified, investors typically get their money first and common shareholders (you) get paid based on what’s left.

There are several questions that you’ll need to address to help guide your decision:

• What % of the company do my options represent? If you don’t already know the number of authorized shares, find out. Your percentage of ownership is determined by dividing your options by the number of authorized shares (Keep in mind that ‘authorized’ is substantially different from ‘issued’ or ‘outstanding’ shares).
• What do the investor preferences look like? If your company has taken multiple rounds of financing, this can be very hard to answer. Management should be able/willing to tell you two numbers:
  • The exit value where common stockholders get nothing, and
  • The exit value that would trigger the preferred shareholders to convert their preferred stock to common stock.
• Can I expect further dilution? (Will the company need to raise more money). If the company will need to raise more capital, dilution will be forthcoming. If the company has lost momentum (or did a very expensive prior round), and needs to raise more capital, expect lots of dilution.

Gauging Future Dilution is hard. Whenever a company raises money, the capitalization table can be entirely renegotiated. This rarely happens at a company with strong momentum that is raising money had a higher valuation than the prior round.

If a company is struggling, the capitalization table can be completely changed. The new investors have tremendous leverage (presumably because others don’t want to invest) and may value the company at a very low amount, effectively washing out prior shareholders. They’ll want to make sure current employees are appropriately incentivized, but former employees are at the bottom of their priority list.

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