Why is determining the strike price of stock options important?

The strike price of an option is the cost of exercising a put or call option. When deciding on a certain option, a company must decide on one of two essential selections (the other being the strike price). The strike price significantly impacts how your option trade will play out.

So how does one pick the right stock options strike price for its investor? In this article, we will look at why determining the stock options strike price is important and how it may affect your startup if done wrongly.

How do stock options work?

When starting a company, most startup entrepreneurs would not have enough capital to fund experienced employees. In order to attract good employees into the company’s business. The employer typically provides stock options in the form of an ESOP (employee stock ownership plan), allowing employees to own a portion of the company. This means that if the company is able to grow and expand, the stock goes up, and they, in turn, make money from it.

Understanding how stock options work is really important. Let’s look at the breakdown and understand the importance of each part.

Understanding Strike Price

A strike price is vital in determining how many shares you can buy. The strike price is the price at which employees can purchase business stock. Profits will be earned in the future if the share price climbs over the strike price. Employees who join a firm early in its journey typically have a lower strike price than those who join a later or growth-stage startup. Understandably, they are taking more risks when the company is still not as developed.

In that regard, how does a startup determine the strike price of stock options, and how can you tell if it’s a fair valuation? The IRS provides particular guidelines on setting strike prices, which focus on determining the stock’s fair market value (FMV) at the time of issue. Determining the FMV of the stock can be a difficult and opaque procedure, but Section 409A gives structure. Following the 409A valuation, a strike price that cannot be lower than the FMV is assigned to the shares.

That is why the strike price has to go hand in hand with the 409A valuation in determining the right stock options strike price.

Understanding 409A Valuation

The 409A valuation is the one that will drive the strike price and have an impact on employee profitability in the future. This assists the employee in understanding the valuation of common stock as opposed to the potentially greater valuations granted to preferred equity. The 409A valuation of ordinary stock may be much lower than the valuation of preferred stock in later stage or development stage organizations. In these circumstances, the employee may gain from the ultimate and hoped-for convergence of preferred and common stock valuations.

The IRS’s prescriptive advice and sequencing to determine FMV is a 409A valuation. Its principal function is to provide transparency and protect potential option grantees. The valuation is then divided into three distinct stages:

Finding the EV (Enterprise Value)

There are 3 different ways you can calculate and find out about companies EV, which are:

1. In early-stage companies, the market method is used to compare the company to a collection of market-equivalent peers. For example, an early-stage software company that is not yet profitable is compared to more established software companies to obtain a relative valuation.
2. When a startup is profitable or on the verge of being profitable, and financial performance can be predicted more accurately, the income technique is applied. EV is calculated using revenue modeling based on past performance and growth projections.
3. The asset strategy is employed early on, frequently for company pre-financing. It calculates EV using a one-for-one replacement cost based on an evaluation of the company’s assets and liabilities at the time of valuation.

Finding the true value of the Current Shares

The current share value can be calculated by taking the startup’s EV and dividing it by the number of existing share classes (preferred, common, etc.). Because share classes might differ greatly, their weighted EV can be calculated in one of three ways:

1. The Options-Pricing Method provides a strike price to each share class and treats them as hypothetical call options (an option granting the opportunity to buy at a specified strike).
2. The most well-known strategy is the Black-Scholes Method, which employs a sophisticated formula that gained a Nobel Prize to account for time, current stock price, risk-free rate, and other variables. It is not an easy procedure, but it is the most dependable and is extensively utilized in private startup option awards and publicly traded options pricing.
3. The Probability-Weighted Expected Return Method considers a number of contingencies as well as potential company-wide outcomes. It compares each to its likelihood of occurrence. In the contract or term sheet, the agreed-upon rights govern the exact outcomes of the share class or series.

What happens if the stock options strike price is miscalculated by startups?

Now that you understand the importance and the in-depth understanding of why determining the stock options strike price is important. Startups need to properly calculate and determine the right value strike price to comply with the IRS 409A valuation.

The financial ramifications of 409A noncompliance might be severe for your employees. If the IRS intervenes and determines that your 409A valuation does not fall inside the safe harbor, all of the stock you distributed to your employees under that FMV — not just the current taxable year but any prior year — is included in their gross income (including interest owing) all at once in that year. The IRS may potentially charge a penalty of up to 20% on stock options that vested prior to the tax year.

Therefore, startups should take the time to manage their stock options in order to not only protect the company. Most importantly, protect the employees with ESOP who risk working with the company.

Need Help?

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