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Disclaimer: I am not a lawyer or tax attorney. Please consult with one before making any financial decisions as to what to do or not do with your options.

Stock options are complicated; the paperwork that accompanies them can sometimes be a full inch thick of financial legalese. Most employees are just glad to get some ownership in the company — and maybe a lottery ticket if the startup does really well. But most employees don’t recognize what their options really are, nor do they understand that there are some catastrophic choices they can make with those options that could leave them bankrupt or worse.

For the executive summary: If you can afford it, forward-exercise 100 percent of your options the week you join a startup and file an 83(b) election immediately.

Here are five common mistakes employees make, as well as why they spell bad news.

1. Believe that a fortune awaits

Many employees join a startup and work incredibly hard at a sub-market salary for years in the hopes of “striking gold.” The sobering math around startup exits, however, is that unless you’re one of the very first few employees, you’re probably not going to get more than a nice hiring bonus, even if the company does pretty well for itself.

Let’s say you’re employee No. 20 at a Valley startup. By usual Valley standards, if you’re a fabulous developer, you’ll probably get a four-year option package worth about 0.2 percent of the company. Two years after you join, the company sells for $30 million. Wow, that sounds like a lot of money! You’re rich! Right?

Not so fast. If the company has taken $10 million of financing (at a 1x preference) that leaves $20 million to be split among the shareholders. You’ve vested half your 0.2 percent, so you get 0.1 percent, or $20,000 before taxes. Since exits are taxed federally as income (~25 percent) and you live in California (~9 percent state tax), you get to keep $13,200. That’s $550 for each of the 24 months you just worked your ass off. Oh, and in many deals, most of this money is not doled out right away to employees. It’s only offered after one to three years of successful employment at the acquiring company, to keep you around. Oy.

So if you join a startup, you should do so because you love the environment, the problems and your coworkers, not because there’s a giant pot of gold at the end of the rainbow.

2. Quit with unexercised options

Most employees don’t realize that that the unexercised options they worked so hard to vest completely vaporize after they leave the company, usually after 90 days. If you haven’t exercised your vested options, your ownership goes to zero. Even if the startup eventually gets acquired for a billion dollars, you get zilch. So if you join a startup and don’t exercise, you should probably try to stick it through to an exit.

3. Wait until the company is doing really well to exercise

This mistake can catch a lot of otherwise smart people. They join a startup, work hard and see the company grow. Then after a few years they say: “Wow, the company just raised a huge round or has promising prospects to be acquired for a lot of money or file for IPO! I should exercise those stock options I haven’t been thinking about!” These people usually don’t bother to talk to a tax attorney or even a mentor; they just fill out their options paperwork, write a small check, and the company duly processes it. The employee feels not only pumped but really, really smart. After all, they just paid this tiny price to exercise their options, and in return they get this big wad of super-valuable stock!

They usually don’t realize – at least, not for some time — that the IRS considers this exercise a taxable event under the Alternative Minimum Tax because they just got something that’s worth more than what they spent on it. The IRS does not care that you don’t actually have the cash on hand to pay this tax. Nor do they care that you can’t even sell off some of the stock to pay for the tax. They are brutal.

In two cases, friends of mine had to arrange for a decade-long repayment period to the IRS for hundreds of thousands of dollars, wiping out their savings and their next decade of earnings. In both cases the stock that my friends exercised was ultimately rendered illiquid/worthless. Ouch.

4. Fail to early exercise

Most startup employees don’t realize that it’s possible to ask to “forward exercise” their unvested options immediately after receiving their options grant. “But wait!” they cry, “with a one-year cliff, my boss told me none of my options will vest at all until I’ve worked a year!”

Perfectly true. But follow this carefully: Your option vesting schedule covers your right (“option”) to purchase Common Stock. If you exercise your option before it vests, you’ll receive not Common Stock but Restricted Stock instead. Restricted Stock can be purchased back from you by the company at the amount you paid for it if you quit.

Let’s say you think you’re really clever and join a company. The next day, you forward-exercise your four-year option package and quit. The company will simply buy back all of your restricted stock, and you’ll end up with nothing. The restricted stock vests into common stock at the same schedule as your options vest. So if you did a forward exercise, on your one-year anniversary a quarter of your restricted shares “magically” (with no paperwork to fill out or action to take) become common shares that the company cannot force you to sell if you leave.

This also means you get to start the clock ticking on long-term capital gains, which is currently 15 percent in the US! So if your company does end up hitting a liquidity event, a much smaller portion of your gains will be taxable. Indeed, if you hold on to your stock for more than five years, you might be eligible to roll over all of the proceeds into another qualified small business completely tax-free!

5. Fail to file an 83(b) election

Some folks who are clever enough to realize that they can exercise early unfortunately forget that they need to tell the IRS to recognize the event with a form called an 83(b) election. Without an 83(b), your vesting is counted as income under AMT since your restricted stock that you paid $X for is converting into common stock that’s worth more ($Y>$X), since hopefully the company is getting more valuable.

The 83(b) tells the IRS that you’d like to immediately “fast forward” all of the tax impact, so pretty please tax you now for your gains. But since you’re paying fair market value for the common stock, there are no gains, so you pay no taxes at all! Clever you. As long as you file your 83(b) with the IRS within 30 days of your forward exercise and include it again in your annual personal income tax return, you’ll be in the clear regarding AMT.

If you found this helpful, check out my Guide to Stock & Options, embedded below.

[scribd id=55945011 key=key-dabr15b167c296f9mi5 mode=list]

A Stanford CS grad, David Weekly has been coding since he was five and loves bringing people together and starting things, including PBworks, SuperHappyDevHouse, Hacker Dojo, and Mexican.VC. He is an award-winning mentor for Founder Institute, i/o ventures, and 500 Startups. He is @dweekly on Twitter and can be reached at [email protected]

Image courtesy of Flickr user alancleaver_2000