[zaroth]

I think the problem is with your $1.2M valuation. You have a company with $2m in preferences or debt which is first in line before any common stockholder, and most likely their liquid assets are less than $2m, and they have negative net income. That makes the common stock effectively worthless at this time.

Also, if you keep reading;

  Once our valuation rises and the cost becomes prohibitive, we’ll move to an
  extended exercise period model instead, where you will have 10 years to
  purchase your options. By that time we’ll either have had an exit (in which
  case you can do a cashless exercise), or we will have arranged some other
  form of liquidity.

[throwaway1124]

I'm not suggesting that the valuation is truly worth $1.2M but if they did a 409A valuation or had their board decide on the FMV to determine strike price, the value would be at least 15% of the post-money valuation. My point is simply that if they've issued a reasonable number of options (over 0.25% of the total authorized shares), there is no way that their employees would only pay a few hundred dollars to exercise.

In an extended exercise period model, there's still the issue of Alternative Minimum Tax on exercise or long-term vs. short term capital gains. There will also likely be lockups on those shares whether inherently built in or in an eventual IPO.