The Tax Domino Effect of Exercising Startup Options Too Late

One of the most expensive mistakes in startup equity is exercising options too late.

Not because the company failed or the exit disappointed, but because the tax dominoes fell all at once.

This mistake rarely feels obvious early on. When a company is small, valuations are low, and liquidity feels far away, exercising options can seem optional. Cash feels more useful than illiquid stock, and waiting feels conservative.

Then time passes. The company grows. Valuations rise. A decision that once felt flexible becomes constrained by taxes, timing, and liquidity rules that are no longer fully in your control.

Here is how that sequence usually unfolds.

First Domino: Higher Taxes

As a company’s valuation increases, the spread between your strike price and the fair market value grows. That spread is where taxes live.

For non-qualified stock options, exercising creates ordinary income equal to the spread, even if you do not sell a single share. For incentive stock options, the spread can trigger alternative minimum tax (AMT) exposure, again without any liquidity.

In both cases, the tax bill is based on paper value, not cash in your bank account.

Early on, this spread may be small enough that the tax impact is manageable or nonexistent. Later, that same exercise can result in a six- or seven-figure tax bill. The underlying decision did not change. The timing did.

Second Domino: Fewer Levers to Pull

Early exercise creates flexibility. You can decide how much to exercise, spread exercises across multiple tax years, and manage income thresholds and AMT exposure more intentionally. You also start long-term capital gains clocks earlier, when the numbers are smaller and the risks are clearer.

Late exercise removes many of those levers. As companies approach an IPO or acquisition, option decisions often get compressed into a narrow window, driven by deal timelines, expiration rules, or internal pressure once liquidity becomes visible.

Decisions that could have been staged over years are suddenly forced into a single moment. No one wants to be forced to play their hand.

Third Domino: Taxes Before Liquidity

This is the part that catches many people off guard. You exercise your options, trigger a large tax bill, and still cannot sell.

Lockups, blackout periods, and deal terms often delay access to cash. Even in acquisitions, payment structures may include escrows or earnouts that postpone liquidity.

The result is a mismatch. Your equity may be illiquid, but the IRS does not wait. Estimated taxes are due, penalties apply if you miss them, and the obligation is real even if the value that created it is not accessible yet.

Fourth Domino: Concentration Risk

Waiting to exercise often means waiting to diversify. When options remain unexercised, there is nothing to sell and nothing to rebalance, so risk quietly compounds as more of your financial life becomes tied to one company.

By the time liquidity finally arrives, most of your net worth may be concentrated in a single stock and realized in a single tax year. At that point, diversification becomes reactive instead of planned, driven by tax deadlines or market volatility rather than strategy.

Fifth Domino: Regret Disguised as Bad Luck

After the dust settles, many people describe the outcome as unavoidable. Sometimes that is true. Success does come with taxes.

But often, it was not the tax rate that caused the pain. It was the loss of optionality. Earlier decisions could have created more paths, more time, and more flexibility. Once valuation rises and liquidity approaches, those paths quietly close.

This Is Not a Pitch for Early Exercise

Early exercise is not a universally good idea. It requires cash and introduces real risk. You are buying illiquid shares that may never be worth anything. For some companies, roles, and personal balance sheets, waiting is absolutely the right call.

The goal is not to exercise as early as possible. The goal is to understand what waiting costs you in flexibility.

Option Timing Is a Sequencing Decision

Most people think about option exercise as a tax decision. It is more accurate to think of it as a sequencing decision.

I think about this the same way I think about golf. The scorecard gets all the attention, but the result is usually determined much earlier. Club selection before the wind shifts. Laying up instead of forcing a shot. Decisions made when you still have options. Once you’re in trouble, you’re no longer choosing the best shot. You’re choosing the least damaging one. Equity timing works the same way.

The real questions tend to be:

• What choices are available to you today that will not be available later?
• Which levers disappear as valuation increases?
• What risks are you comfortable taking now versus being forced to take later?

Doing nothing is still a decision. It just feels passive.

Once valuations rise, flexibility disappears faster than most people expect.

With startup equity, the outcome usually gets all the attention. The exit. The IPO. The headline number.

But timing is what actually drives the result, long before liquidity is on the table.