Equity compensation can be one of the most powerful wealth-building tools for early-stage employees and executives of private companies. Unlike public company stock, private equity compensation exists in an illiquid environment, meaning your timing, potential tax liability, and risk management decisions may become more complex.
Whether you’re in the early stages of a private startup or approaching a long-anticipated IPO, it’s important to understand how to best manage your incentive stock options (ISOs) at each phase of the company’s growth.
First, a Reminder About ISOs
ISOs give employees the right, but not the obligation, to purchase a specified number of company shares at a predetermined price (called the exercise price) during a defined term (often up to 10 years).
The grant date is the day the ISO award is issued, and the exercise price (the price at which you can purchase the stock) is often set as the fair market value (FMV) of the company’s stock on that date.
ISOs may earn preferential long-term capital gains treatment if they’re sold after meeting statutory holding periods in a qualified disposition. However, exercising and holding ISOs can also trigger the Alternative Minimum Tax (AMT).
When you exercise and hold ISOs, the IRS views the difference between the fair market value (FMV) at exercise and the exercise price (known as the bargain element) as income for AMT purposes—even though no sale has occurred
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With the fundamentals of how ISOs work in mind, let’s take a look at how they can be addressed during different stages of a private company’s lifecycle.
Early Stage
In a private company’s early stages, it’s unlikely any meaningful or consistent growth has occurred yet. Your company’s roots are still being established, and the fair market value may remain relatively steady or rise incrementally. (Note that this is all a generalization, and every company’s growth trajectory is different.)
If you’re awarded ISOs in the early stages, and the FMV of the stock is close to the exercise price, an exercise may be something to consider. In doing so, you may not get much of a “discount” on the shares, but you do get to exercise at a relatively inexpensive tax cost.
This is because AMT calculations include the bargain element of exercised and held ISOs. The smaller the bargain element, the less AMT is owed—or, AMT may be avoided altogether.
Let’s look at an example.
Say you’re awarded 50,000 ISOs with an exercise price of $1/share. At the time you choose to exercise, the FMV is $1.25/share. Exercising all 50,000 shares would cost $50,000, with a bargain element of $12,500 ($0.25 x 50,000). That $12,500 is included when calculating the tentative minimum tax (TMT).
Generally speaking, if the TMT is higher than what you owe in regular taxes, you’ll be required to pay AMT. For this reason, a lower bargain element reduces your TMT—ultimately reducing the likelihood of owing AMT.
Now, let’s say you didn’t exercise until later in the company lifecycle, after substantial growth has occurred. While you can still exercise for $1/share, the FMV at the time of exercise is now $12/share. Exercising all shares would cost $50,000 still, but the bargain element jumps to $600,000. Now, the likelihood of owing AMT is much higher.
Keep in mind that in addition to potential AMT, you’ll want to be aware of the cost to exercise the option itself. Going back to our example above, you’ll need $50,000 to exercise and hold the shares. This means you’ll need to put $50,000 into a private company, one with no liquid market and potentially no chance to sell the stock. Prior to exercising and holding to mitigate AMT, you’ll want to consider if you can (and should) afford this cost as well.
Starting the Clock for Qualified Small Business Stock (QSBS)
Qualified Small Business Stock (QSBS) can be a valuable, and sometimes overlooked, provision for startup employees. To qualify, the issuing company must be a C-corporation with gross assets under $75 million at the time the stock is issued—note that the ISOs need to be exercised in order to be considered “issued”. For shares issued before the One Big Beautiful Bill (OBBB) was passed on July 4, 2025, the gross asset threshold was $50 million.
As an employee and participant, you must hold the stock for at least five years before selling. If those conditions are met, you may be eligible to exclude up to $15 million (or $10 million for shares issued before July 2025) or 10 times your cost basis (whichever is greater) of gains when you do eventually sell.
For shares issued after July 4, 2025, you may also benefit from a partial exclusion depending on when you sold your shares, even if you don’t meet the five-year mark.
By exercising early on in the company’s lifecycle, you start this five-year holding period while the company’s valuation is still relatively low, setting the stage for potentially significant tax savings if the company experiences success later on.
QSBS eligibility can be complex, and not all business types qualify. Confirm with your company and your advisor that your shares meet the requirements before making important decisions that could affect your future tax liability.
Early Exercise and Filing an 83(b) Election
In some companies, you may be allowed to exercise your ISOs early (early in this sense means prior to the options vesting). An early exercise, coupled with filing an 83(b) election within 30 days of exercise date, is a tax strategy that allows you to recognize income sooner rather than later, hopefully when the spread between the exercise price and the FMV is at its smallest. However, an 83(b) election on ISOs is only applicable for AMT purposes, not for regular income tax purposes.
Let’s imagine you’re granted 100,000 ISOs with a $0.20/share exercise price while your company’s stock is valued at $0.25/share. Because your ISOs are early-exercisable, you decide to exercise immediately and pay $20,000 to purchase the shares. This creates a bargain element of $5,000.
If you file an 83(b) election, you report that $5,000 spread as income for AMT in the year of exercise. The tax impact in this example will be minimal since the spread is relatively small.
Exercising early and filing an 83(b) begins the holding period for AMT on ISOs. However, the generally accepted belief is that your long-term capital gains and QSBS (if applicable) holding periods are both still tied to the original vesting schedule of the individual grants, even if you file an 83(b).
A Potentially Better Strategy
While the general consensus is that ISOs are preferred to NQSOs due to the potential for preferential long-term capital gains tax treatment, an early exercise of stock options might be an instance when NQSOs are, in fact, the better choice.
While early exercise of ISOs and an 83(b) is only effective for AMT purposes, early exercise of NQSOs with an 83(b) is effective for ordinary income purposes. This is because the holding period for both LTCG and QSBS is initiated on the exercise date and not the vesting date.
If you’re in the negotiation stages of a compensation agreement with your company and plan to exercise options early, it may be wise to, in fact, request NQSOs over ISOs.
Later Stage
As valuations climb, the decision to exercise ISOs can become more expensive and complex. First, the options issued at a later date might have a higher exercise price. The higher the exercise price of the ISO, the more cash is required to buy and hold the ISOs themselves. Additionally, a later-stage company might have a higher 409(a) valuation. This can lead to a greater bargain element at exercise, resulting in a higher AMT.
Preparing for Liquidity Challenges
Both of these scenarios present potential cash calls and liquidity issues because, as a private company, there are limited (or no) opportunities to sell private company stock prior to an IPO. That means that even if you incur AMT after exercising ISOs, you may not be able to sell shares to cover the tax bill.
Let’s say you hold 20,000 ISOs with a $5/share exercise price. The company’s latest valuation shows $20/share. Exercising all 20,000 ISOs would cost $5 x 20,000 ISOs, or $100,000. The bargain element of $15 x 20,000, or $300,000, becomes part of your AMT calculation, potentially triggering a tax bill north of $78,000 (assuming a flat 26% AMT rate). You’ll need cash reserves or liquid assets to cover the cost of exercising and AMT, which may strain other areas of your financial life—especially if not planned for proactively.
This example represents one of the primary challenges private company employees face when managing ISOs. You may want to exercise and hold, initiating the holding period for a qualified sale, but you may also owe tax on paper gains without any corresponding liquidity to cover it. Even more, if you exercise and hold, and the company never has a liquidity event, your ability to recoup AMT via AMT credits may be limited. It could take years to incur additional AMT income liability without selling your ISOs, as AMT credits are most commonly returned in years when you experience a significant liquidity event (like the sale of employer stock).
In fact, it’s possible the AMT “prepaid” on your exercised and held ISOs may never be recovered at all if the company declines in value (or fails altogether).
Later-Stage Tender Offers
Some mature and late stage private companies like SpaceX and Stripe hold tender offers, which allow employees to sell a portion of their private shares back to the company or to third-party investors. These opportunities are important, as they enable employees with previously illiquid ISOs to cash in on the accrued value. They may also be the only time when you’re allowed to sell some portion of your shares until there is a future liquidity event.
Let’s say you exercised ISOs three years ago. Now, with a tender offer on the table, you may decide to sell some shares. Because you meet the criteria for a qualified disposition, you can benefit from the more favorable long-term capital gains tax rate when selling. You may then decide to use the returns to diversify your portfolio, fund a personal goal, or cover the cost and potential tax of exercising more ISOs.
Nearing IPO
As a private company approaches the public markets, employees may feel compelled to exercise ahead of the IPO in anticipation of a post-IPO “pop.” While this strategy can be tempting, the timing around an IPO introduces some additional layers of risk and potential tax complications.
Exercising ISOs before an IPO would enable you to start the long-term capital gains holding period before the company’s stock begins trading. However, to actually receive long-term treatment, you must meet the criteria for a qualified disposition—namely, hold the shares for at least one year post-exercise and two years post-grant. If you choose to sell earlier, you’ll ed up with a disqualified disposition and pay ordinary income tax on any gains. This means that you’ll likely need to hold the stock longer than even the standard post IPO 6 month lock up period.
An upcoming IPO creates an exciting opportunity for employees to transform paper value into real, tangible gains. It’s important to consider all possibilities surrounding this liquidity event and how they could impact your portfolio and potential exposure to risk. It’s not unheard of for IPOs to be delayed, restructured, or, in some cases, cancelled altogether. Exercising in anticipation of a liquidity event that doesn’t arrive could leave you concentrated in an illiquid company stock and responsible for an AMT bill.
If you plan to diversify soon after an IPO, it may make more sense to hold off on exercising all ISOs until closer to the liquidity event. Then, rather than exercise and hold, sell immediately (even as a disqualified disposition) to avoid unnecessary AMT exposure.
Need Help Managing Your Private Company ISOs?
Each stage of a private company’s evolution presents its own mix of tax, liquidity, and valuation considerations that you’ll need to weigh carefully when managing ISOs.
Incentive stock options can offer tax-advantaged growth opportunities for private company employees, but those benefits generally hinge on timing and some proactive consideration. Each stage of a company’s growth shapes how you should think about exercising, holding, or selling your ISOs.
In a company’s early stage, when valuations and FMVs are still low, exercising ISOs can minimize AMT exposure. As valuations rise, so does the bargain element and with it, an increase in potential AMT liability.
Tender offers, secondary markets, and anticipated IPOs in later-stage companies may create windows for selling ISOs—but with those opportunities come important considerations surrounding liquidity needs and timing.
Understanding the potential advantages and trade-offs of exercising or selling ISOs in various stages of the private company lifecycle can help you maintain greater control over your cash flow, stock concentration, and tax situation.
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