If you are a startup founder, offering stock options can be a powerful strategy to attract and retain talented employees without using too much cash. Before granting stock options, however, founders must decide on the right exercise (strike) price.
The exercise price is more than just the cost of purchasing shares; it also affects tax treatment and compliance requirements. Private companies use a 409A valuation to determine fair market value and set an appropriate exercise price.
Understanding how a 409A valuation affects the exercise price helps companies grant stock options fairly, comply with legal requirements, and avoid costly mistakes as they grow.
This guide explains how a 409A valuation determines the exercise price, why it matters, and what startup founders should know before granting stock options.
What is a 409A valuation?
A 409A valuation is an appraisal that determines a private company’s fair market value (FMV) for its common stock. Private companies generally rely on this valuation to support option pricing and comply with Section 409A of the Internal Revenue Code.
Since startups aren’t publicly traded, there’s no market price for their shares. A 409A valuation estimates the fair market value of the company’s common stock, making it easier to set stock option prices and support other equity compensation decisions.
Maintaining an up-to-date 409A valuation is essential. Startups should update it annually or sooner if a major event, such as a funding round or acquisition, significantly impacts the company’s value.
What is the exercise (strike) price?
The exercise price, also called the strike price, is the amount employees pay to buy company shares when they exercise stock options.
This price determines the potential value of an option. If the company’s share value rises above the exercise price, employees may buy shares at the lower predetermined price and potentially profit from the difference. If the share value stays below the exercise price, exercising the option may not make financial sense.
For startups, choosing a reasonable exercise price is an important part of creating a fair, transparent equity compensation plan that supports the company’s long-term goals.
How does a 409A valuation determine the exercise price?
A 409A valuation provides an independent estimate of a company’s common stock value, which companies use to set the exercise price for new option grants at or above fair market value.
Valuation specialists consider financial performance, funding history, comparable companies, industry outlook, intangible assets, and growth potential. Depending on the company’s stage and circumstances, it may use the income, market, or asset approach, or a combination of methods.
How does the 409A strike price impact employees?
The exercise price plays a major role in determining how much employees may benefit from their stock options. If the company’s share value rises above the strike price, employees may be able to buy shares at the lower price and potentially make a profit, depending on the terms of the stock option plan and applicable taxes.
Stock options are generally described using two common terms:
- In the money: The company’s current share price (or fair market value) is above the option’s strike price, so the option has intrinsic value. If the option is exercised while it is in the money, the employee can buy shares below their current market value.
- Out of the money: The company’s shares are worth less than the exercise price. If the share price remains below the strike price, exercising the option is generally a poor financial decision.
A lower exercise price may result in more upside; however, employees should consider taxes and personal financial factors before deciding to exercise.
Understanding the exercise window and Post-Termination Exercise Period (PTEP)
Being granted stock options does not necessarily mean employees are allowed to exercise the options right away. In most cases, the option plan explains when options may be exercised and how long employees have to act.
Exercise window
Once stock options have vested, employees have a certain amount of time to exercise them. This is called the exercise window. During this time, they can buy company shares at the agreed-upon strike price. While many companies allow up to 10 years from the grant date, the exact period depends on the company’s stock option plan.
Post-Termination Exercise Period
When employees resign, they don’t usually lose their vested stock options immediately. They are usually given a period of time to exercise them. For instance, 90 days is a common grace period that most companies adopt. However, there are some companies that may extend the time period to exercise or provide special arrangements if the employee retires, becomes disabled, or passes away.
Factors Employees Should Consider Before Exercising Stock Options
Exercising stock options is a major financial decision that has a lot of costs and risks, so it should be considered carefully.
- Company performance and outlook: A company with strong growth, healthy revenue, and a credible path to a liquidity event may make exercising options more attractive than one facing stagnation or uncertainty.
- Market conditions: Broader market conditions, including investor appetite, interest rates, and IPO or M&A activity in the sector, affect how likely it is that private shares will eventually become liquid.
- Option expiration timeline: In many cases, options will eventually run out. Employees should keep a close eye on vesting schedules, option expiration dates, and post-termination exercise periods (PTEPs) so that they do not lose the options they have been granted.
- Tax considerations: When you exercise an option, tax liability can arise even if the shares are not sold. This is particularly an issue with ISOs, where in some cases AMT may be triggered, so planning ahead is important.
- Financial capacity and goals: Exercising options requires cash and increases exposure to an illiquid asset. Employees should weigh this against their savings, cash flow, debt repayment needs, risk tolerance, and other financial responsibilities, since not everyone has the ability to exercise and pay the related taxes.
How are employee stock options taxed?
Tax treatment differs significantly depending on the type of option granted, and this affects both when taxes are owed and how much.
Non-qualified stock options (NSOs)
NSOs are generally subject to taxation at the time of exercise. The taxable amount is the difference between the stock’s fair market value at the time of exercise and the strike price. This difference is typically treated as ordinary income and is subject to income and payroll taxes. Any additional gain or loss after exercise, when the shares are later sold, is generally taxed as a capital gain or loss.
Incentive stock options (ISOs)
ISOs have more favorable tax treatment. Normally, no regular tax payment is due upon exercise, but the spread may trigger the AMT. Gains on sale are generally taxed at long-term capital gains rates instead of ordinary income rates if the shares are held at least one year after exercise and two years after grant.
Common mistakes startup founders should avoid
Avoiding common mistakes when granting stock options can help founders prevent future compliance issues.
- Issuing stock options before obtaining a current 409A valuation.
- Using a valuation that is no longer up to date after a major business event.
- Delaying option grants long after the valuation date without confirming whether FMV has changed.
- Failing to maintain appropriate records that support option grants.
- Treating the amount paid by investors for preferred shares as equivalent to the price of common shares.
A well-managed equity compensation practice is an effective way to minimize compliance risks and build mutual trust between the company and its employees.
FAQs on 409A Valuation and Stock Option Exercise Price
Below are answers to some of the most frequently asked questions to help clarify key concepts and common concerns.
Can a 409A valuation be challenged by the IRS?
The IRS can still challenge a valuation if its methodology, assumptions, or supporting documentation are unreasonable, or if it no longer reflects the company’s current circumstances.
How does a company’s funding stage affect its 409A valuation?
Later funding rounds often result in higher 409A valuations because they usually reflect a growing business and increased investor confidence. Valuation specialists consider these and other financial factors when determining the fair market value of the company’s common stock.
Does a higher 409A valuation always benefit employees?
Not always. Because the 409A valuation sets the minimum strike price for options, a higher valuation raises the exercise price on new grants, reducing their immediate built-in value and making them more expensive to exercise.
How does a company’s capitalization table affect a 409A valuation?
A cap table shows how ownership is divided among founders, employees, investors, and option pools. In addition, valuation experts use the information in the company’s cap table to help determine the fair market value of its common stock for 409A purposes.
Maintain an Accurate 409A Valuation
As your startup grows, stock options become more than a motivational tool. They become an essential part of a scalable equity compensation program. Taking the time to obtain an accurate 409A valuation, maintain proper documentation, and review the valuation after major business events can support your company’s long-term growth.
If you’re planning to offer employee stock options, obtaining an independent 409A valuation is considered a best practice and the most common way to qualify for 409A safe harbor protection. Cheqly‘s partner, Eqvista, can provide one. Their experienced valuation professionals provide thorough, unbiased 409A valuation services, helping startups determine the fair market value of their common stock with strong supporting documentation and confidently set the exercise price for employee stock options.