Chris, this is not necessariiy the case. Non-employee Directors and advisors are not generally eligible for ISOs, so they get non-quals. When non-quals are exercised, ordinary income tax is due on the gain. This is true regardless of whether the underlying stock is sold, so you may well have taxes payable on unrealized income. This is a major disadvantage to non-quals. Gains after the date of exercise are eligible for capital gains treatment going forward assuming you meet the holding period requirements.

It is true that there is no tax payable upon the grant of the stock. In a true raw startup though, the common stock often has so little value that you may be better off getting the stock and paying the nominal amount of tax. Obviously, that is not the case in later stage companies.

Don’t even get me started on how AMT destroys the supposed tax advantages of ISOs for many people.

And yes, the tax benefits of taking options at the onset should more than offset the strike price.

When faced with first time entrepreneurs, we always are upfront about pointing out that as investors – all other things being equal (which isn’t always the case admittedly) – it is in our interests to wait for the reasons Chris points out above. Honesty is the best policy. However (good) investors know this strategy also has risks (ie the option isn’t completely free): the entrepreneur could find another investor, the opportunity might fade and/or execution risk become higher by delaying, etc.

As an investor, if you truly believe in the team and the opportunity, you will want to ‘move the ball down the field’ promptly and your interests quickly become aligned with the founder(s). It’s not a science but an art as to how quickly or slowly to move and is entirely dependent on the particular dynamics of the deal and company in question.

Again, imo the key is to be upfront and transparent about this with the founder and keep the dialog open at all times. Doing otherwise is not only cynical but ultimately bad business: in-the-money options that you let expire worthless are just that.