In the world of startup equity and compensation, the terms exercise price and strike price are used interchangeably. They represent a specific, pre-determined price at which an option holder can buy stock in the company.
This figure is crucial because it dictates the cost of entry for ownership. When you offer stock options to employees or receive them as a founder, you are not giving away shares. You are giving the right to purchase shares later at today’s price.
The Mechanics of the Strike Price
#The exercise price is set at the time the board of directors approves a stock option grant. It is typically locked in for the life of the option, which is usually ten years.
This mechanism is designed to incentivize growth.
The logic is simple. You set the price today. If the company increases in value over the next few years, the holder can still buy the stock at the old, lower price.
Consider this example:
- You grant an employee 1,000 options.
- The exercise price is $1.00 per share.
- Four years later, the company stock is worth $10.00 per share.
The employee pays $1,000 to exercise the options. They receive stock worth $10,000. The profit or value created is the difference between the two numbers.
Exercise Price vs. Fair Market Value
#It is important to distinguish between the exercise price and the Fair Market Value (FMV).
The FMV is the current value of a single share of common stock. This is usually determined by an independent 409A valuation.
When options are granted, the exercise price must be at least equal to the FMV at that exact moment. This ensures compliance with tax laws. If you set an exercise price lower than the current value, it creates immediate tax liabilities and penalties.
However, once the grant is made, these two numbers diverge.
- Exercise Price: Remains a flat line. It does not change.
- Fair Market Value: Hopefully moves upward as the company executes its business plan.
The widening gap between the fixed exercise price and the rising FMV represents the potential financial upside for the option holder.
Scenarios and Outcomes
#Understanding the relationship between the strike price and the current value is vital for making decisions about when to exercise.
There are generally two states an option can be in.
In the Money This occurs when the current value of the stock is higher than the exercise price. If the stock is trading at $5 and your strike price is $1, you are in the money. Exercising here usually makes financial sense if you have the liquidity to do so.
Underwater This happens when the current valuation drops below the exercise price. If the strike price is $5 but the company has struggled and the stock is now valued at $2, the options are underwater.
In this scenario, purchasing the stock would cost more than the stock is worth. Holders generally do not exercise underwater options. They simply let them expire.
Founders need to monitor this closely. If a large portion of the employee option pool becomes underwater due to a down round or market correction, the equity no longer serves as a retention tool. You may need to look at repricing options, though that comes with its own legal and administrative complexities.