What is Exercise Price?
Exercise price (also called strike price) is the price an option holder pays to convert their options into actual shares. It's set at the fair market value when options are granted, based on a 409A valuation.
The difference between exercise price and current value is the option's intrinsic value.
Why Exercise Price Matters
Lower exercise price means cheaper shares and more profit potential. Early employees get lower exercise prices because the company's 409A valuation is lower. As the company grows, new grants have higher exercise prices.
Exercise price also affects tax treatment. The difference between exercise price and fair market value at exercise creates taxable income or AMT liability.
409A Valuation
Companies must get independent 409A valuations to set defensible exercise prices. Granting options below fair market value triggers immediate taxation and penalties. 409A valuations are typically updated annually or after significant events.
Formula
Exercise Cost = Exercise Price × Number of Options
Bargain Element = (FMV - Exercise Price) × Options Exercised
Bargain element is taxable income (for NSOs) or AMT (for ISOs)
Example
Your SaaS startup grants options to an employee:
- Grant date: January 2024
- Exercise price: $0.50 (409A value at grant)
- Current 409A value: $2.00
- Shares vested: 10,000
Cost to exercise: 10,000 × $0.50 = $5,000
Paper value: 10,000 × $2.00 = $20,000
Paper gain: $15,000 (but taxable as income)