What Determines a Stock Option’s Strike Price?
A stock option’s strike price is one of the key factors to consider when deciding if and when to exercise that option. Otherwise known as the “exercise price,” the strike price determines what you’ll pay for each share at the time of exercise.
The value of your stock options, then, is based on the difference between your strike price and the current fair market value of the stock. If your strike price is lower than the current value of a share of stock, your options are worth something. But if your strike price is higher than the current value of the stock, well, your options aren’t worth exercising (at least not at the present moment).
All of this probably sounds familiar if you’ve read our guides to startup stock options and how stock options work. But you might still be wondering, What determines a stock option’s strike price in the first place? When you receive a stock option grant with a strike price attached to it, what financial alchemy was done to arrive at that specific strike price?
Let’s unpack how a company, oftentimes with help from an outside firm, calculates a strike price for its employee stock options at a given time (spoiler alert: it’s not alchemy). We’ll also walk through how Pulley can help founders avoid common pitfalls such as overpriced shares, which can demotivate employees and hinder your ability to attract the best talent.
- What is the strike price of an employee stock option?
- What determines the strike price of stock options?
- What is a 409a valuation?
- How to set a strike price for employee stock options
- How the value of stock options can change over time
- Get an audit-ready 409A valuation with Pulley
What is the strike price of an employee stock option?
A stock option is a derivative contract that allows a person to purchase a number of shares of stock at a fixed price. In the case of employee stock options, this person is an employee of the company and the shares in question are shares of company stock. And the “fixed price” at which the employee is allowed to purchase shares? That’s the option strike price.
Remember that options are called “options” for a reason. You aren’t required to purchase any shares of stock at the strike price associated with your option contract—but you do have the option to. Alternatively, you could choose to not exercise your options and just let them pass their expiration date (at which point they become worthless). Whether your options are “in the money” or “out of the money” may help you decide whether to exercise, but the point here is that it’s totally up to you.
“In-the-money” options vs. “out-of-the-money” options
When a stock option is “in-the-money” (or ITM), its strike price is lower than the current fair market value (FMV) of the underlying stock. This means that the option has some intrinsic value, based on what it would be worth if it were exercised today. For example, if your strike price is $5 and the current FMV of the stock is $10, your options are now $5 in the money.
When a stock option is “out-of-the-money” (or OTM), its strike price is higher than the current FMV of the underlying stock. This means that the option has no intrinsic value, because it would be worth nothing if it were exercised today. For example, if your strike price is $5 and the current FMV of the stock is $3, it wouldn’t make sense to exercise your options. You could just buy the stock on the open market for $3 instead of exercising your “right” to buy it for $5!
If you’ve been with a startup since the early days and received stock options as part of your compensation package, you could be in a situation where the strike price of your stock options is much, much lower than the current value of your company’s common stock (i.e. your options are very “in the money”). That’s the power of equity! Few other assets or forms of compensation can multiply in value quite like equity over time.
So, say your strike price really is many times greater than the current stock value. How did this happen? What determined your strike price when you received your option grant? Let’s take a look.
What determines the strike price of stock options?
To determine the strike price of its stock options at a given time, a company needs to know the fair market value (FMV) of its stock.
The fair market value of a company’s stock is the price the stock would have on the open market, if an open market (and symmetrical information between buyer and seller) for the stock were to exist. For some companies, this is easier to determine than for others.
A public company can simply look at the current market price of its stock, which trades publicly on the stock market. This price will likely fluctuate from day to day and week to week, but the current stock price is by definition the fair market value of the stock.
A private company has a trickier scenario on its hands. Since a private company’s stock is not traded on a public stock exchange, the company doesn’t have a value to simply pluck and say, “Aha! This is how much one share of stock is worth!”
This can be problematic. If a private company doesn’t know the current market value of its stock, it can’t offer employees compensation in the form of stock options. For one, the employees would be confused about how the company arrived at a strike price for its options. And just as importantly, the IRS would perhaps suspect that the company is misvaluing itself in an effort to hide taxable income or mislead investors.
The good news is that a private company can determine the fair market value of its stock without guessing or resorting to any chicanery. Instead, it can turn to an appraisal process known as a 409A valuation.
What is a 409A valuation?
A 409A valuation is essentially a rite of passage for any private company that wants to issue stock options to its employees. It is an independent, unbiased process that seeks to determine the fair market value of the company’s stock in a way that complies with IRS regulations.
Once the 409A valuation arrives at an unbiased FMV, the FMV can then be used to determine the price of stock options offered to employees.
How is a 409A valuation calculated?
The factors that go into a 409A calculation can be complicated. With that said, there are a few steps that typically take place during a 409A valuation:
- Calculating the value of the company. There are different ways to do this. A valuation firm might look at the company valuation set during a recent funding round, reference the values of comparable publicly traded companies, or use another method.
- Calculating the value of the company’s common stock. Once you know your company’s value, you can divide and allocate that value across your cap table.
- Applying a discount for lack of marketability (DLOM). A discount may be applied to your share price based on the fact that the shares have no liquidity, i.e. they can’t presently be sold on the open market.
Given the complexity of the 409A valuation process, it often makes sense to partner with a firm that has good experience in your startup’s industry. When Pulley helps startups with 409A valuations, we partner with firms that have worked across a variety of markets, industries, and stages.
Does my startup need a 409A valuation?
If you want to offer stock options to your employees and you aren’t a publicly traded company, yes, you will need a 409A valuation. Companies often complete their initial 409A valuation around the time of their first financing round, so keep that in mind and plan accordingly.
It’s worth noting that a 409A valuation isn’t only useful for determining the FMV of your company’s stock. In theory, you could just make up any old FMV you want and call it a day—ah, but then there’s those pesky folks at the IRS to consider.
In fact, the main reason startups retain a valuation firm to help them with their 409A valuation is to stay compliant with IRS regulations. The IRS grants a status known as “safe harbor” to startups that conduct their 409A valuations according to certain approved methods. This status is essential for allowing you to structure an employee option grant as a tax-free event…which your employees will certainly appreciate!
The bottom line is that a properly executed 409A valuation spits out an FMV that lets you stay compliant with the IRS, which is something you definitely want to do. Now, here’s the good news: Pulley happens to specialize in audit-ready 409A valuations! We even offer free 409A valuations with our Growth plan that you can kick off right inside our online platform.
To learn more about what the 409A valuation process looks like when you use Pulley, schedule a demo with our team today.
How to set a strike price for employee stock options
Once you’ve conducted a 409A valuation and you have a value for your company’s stock, you also have something else: a floor for the strike price on any options you offer employees.
You can’t offer options with a strike price lower than the FMV in your most recent 409A valuation. This would disqualify you from safe harbor status with the IRS.
But what if you wanted to set an option strike price that’s higher than the FMV?
You could theoretically do this, though it doesn’t always make sense. You might consider it if some time has passed since your last 409A valuation and a new funding round that will increase your company’s value is imminent. You might also consider it if your latest 409A valuation is lower than your last but you want to keep offering your employees the same strike price as in the prior round.
Just be aware that prospective employees might balk if you jack up the strike price on the option grants you offer them. Equity compensation, after all, needs to be competitive if it’s going to help you attract the best talent.
How the value of stock options can change over time
Some level of volatility in the value of stock options over time is to be expected.
Depending on the company but also on bigger-picture economic issues, such as the pandemic and/or a recession, whether a stock option is “in the money” or “out of the money” can change based on the FMV of the underlying asset (e.g. a share of common stock).
Get an audit-ready 409A valuation with Pulley
Whether you’re a founder putting together equity grants or an employee comparing grants from different startups, it’s important to understand what determines the strike price of stock options. Misvaluing shares can have consequences, not only in terms of compliance risks but also in terms of the talent a company can expect to attract.
Fortunately, Pulley has your back when it comes to putting together an airtight, audit-ready 409A valuation. We’re the only provider who can deliver you a trusted report in just five days, and we include multiple valuations in each annual Growth or Custom plan subscription. Our 409A valuations have a 100% defensibility rating and are compliant with the highest standards of review. Schedule a call with our expert support team, who can also work with you to create an accurate cap table during onboarding so you’ll be ready when investors come calling.