What Determines a Strike Price?

What Determines a Strike Price?

For startups and companies offering employee equity, understanding the concept of a strike price is crucial.  Strike price is a term that directly affects the value of stock options granted to employees, as well as how attractive and equitable your stock option plans (ESOPs) are.

In this article, we’ll break down the factors that determine a strike price, its impact on equity plans, and what companies and employees need to consider.

What is a Strike Price?

The strike price, also called the exercise price, is the price at which an employee or option holder can purchase company shares through their stock options. It’s locked in when the stock options are granted, regardless of how the company’s valuation changes in the future.

For example, if you’re granted options at a strike price of £1 per share and the company’s valuation grows, you can still purchase shares at that £1 price—even if the market value of the shares rises to £10.

Key Factors That Determine a Strike Price

1. Fair Market Value (FMV)
   In most cases, the strike price is determined by the Fair Market Value of the company's shares at the time the options are granted. FMV represents the price a share would fetch in an open market.

   • Startups often rely on their most recent funding round valuation or a 409A valuation (in the US) to establish the FMV.
   • In Europe, valuations might come from tax regulations or external appraisals, depending on the jurisdiction.

2. Independent Valuations
   To comply with tax laws and avoid penalties, companies often conduct independent valuations, especially in later stages of growth. These valuations provide a third-party estimate of the FMV, ensuring compliance and fairness.

3. Company Stage
   A startup in its early stages might have a lower FMV due to limited revenues and higher risk, leading to a lower strike price. As the company grows and attracts more funding, the FMV and strike price may increase.

4. Jurisdiction and Tax Laws
   Local laws can significantly influence the strike price. For instance:

   • In the US, a 409A valuation sets the FMV, which becomes the baseline for strike prices.
   • In the UK, EMI (Enterprise Management Incentive) options often use an agreed-upon valuation with HMRC.

5. Option Type
   The type of option being granted also plays a role. For instance:

   • Incentive Stock Options (ISOs) in the US usually have a strike price equal to or above FMV.
   • Non-Qualified Stock Options (NSOs) can offer more flexibility, but may have tax implications if the strike price is set below FMV.

6. Board Approval
   Ultimately, the company’s board of directors approves the strike price based on the FMV, legal requirements, and any independent valuation reports.

Why Does the Strike Price Matter?

The strike price determines the financial benefit employees could gain from their options:

• A lower strike price means employees can buy shares at a more attractive rate, creating greater upside potential.
• A higher strike price may discourage employees from exercising options if the company’s share price doesn’t rise significantly.

For companies, setting the right strike price balances compliance, equity attractiveness, and employee satisfaction.

What Should Employees Know About Their Strike Price?

Employees granted stock options should pay attention to the strike price and ask:

• What is the current FMV of the shares?
• How often does the company update its valuation?
• What are the tax implications of exercising my options?

It’s essential to understand that the strike price is just one piece of the puzzle when evaluating the value of stock options. Vesting schedules, exercise windows, and the company’s growth trajectory are equally important.

Conclusion

The strike price is a critical component of any equity plan, and it’s determined by a combination of factors like FMV, valuations, company stage, and tax regulations. By understanding how the strike price works, both companies and employees can make more informed decisions.