Strike Price

A strike price is the per-share price fixed in a stock option that the holder pays to buy the underlying shares when they exercise. It does not move with the market: an option to buy 1,000 shares at a $10 strike lets the holder buy at $10 whether the stock is trading at $4 or $40. The same figure travels under several names. Employees and brokers usually say "strike price" or "exercise price," and Form 3921 for incentive stock options uses "exercise price," while Sections 422 and 423 of the Internal Revenue Code call it the "option price." All three refer to the same number, and knowing that spares a reader the worry that their grant documents, their broker statement, and the statute are describing different things.

How the strike is set on employee options is a legal question, not a negotiation. For an incentive stock option, Section 422(b)(4) requires that the exercise price be "not less than the fair market value of the stock at the time such option is granted." A parallel rule sits in Section 423(b)(6) for a qualified employee stock purchase plan, where the price may be as low as 85% of fair market value. A stricter version of the incentive-stock-option floor applies to an employee who owns more than 10% of the company's voting power: Section 422(c)(5) requires the strike be at least 110% of grant-date value and the term no longer than five years.

At a public company the fair market value is the market price; at a private company it is an appraisal. A private company has no quoted price, so it obtains an independent valuation, commonly called a 409A valuation after the Code section that makes it matter, and sets the strike at the value that appraisal supports. This is why an early employee's strike is low and a later employee's is higher on the same company: each grant is priced to the company's appraised value on its own grant date.

A strike set below fair market value is the trap, and it runs through Section 409A. A discounted option, one whose strike is below the grant-date value, is treated as nonqualified deferred compensation under Section 409A. The consequence is not a smaller tax bill from the built-in discount, it is ordinary income as the option vests, plus an additional 20% federal penalty tax and an interest charge, regardless of whether the option is ever exercised. That is the reason companies pay for a defensible valuation before granting: the point of the appraisal is to establish that the strike was not a discount.

"In the money" and "underwater" describe the strike against today's price. An option is in the money when the share price exceeds the strike, so exercising and selling would produce a gain, and underwater (or "out of the money") when the share price is below the strike, so exercising would mean paying more than the shares are worth. An underwater option is not worthless as a contract, because the stock may recover before the option expires, but it is worth nothing to exercise at that moment. The distance between the strike and the current price, multiplied by the number of shares, is the built-in gain the holder is deciding what to do with.

The strike price does two jobs: it fixes what the holder pays to exercise, and it anchors the tax calculation that follows. The mechanics of exercising and the tax at exercise belong to the option itself, incentive or nonqualified, and are covered on those pages. What the strike price alone determines is the size of the spread.

A hypothetical example, with round numbers chosen for arithmetic. Devon receives an option on 2,000 shares with a strike price of $5, set at the shares' fair market value on the grant date. Three years later the shares are worth $30. Devon's built-in gain is the spread between the $30 value and the $5 strike, or $25 a share, which across 2,000 shares is $50,000. To acquire the shares Devon pays the strike, 2,000 times $5, or $10,000, and receives stock worth $60,000. The strike is the whole reason those numbers exist: had it been set at $30 to match the current price on the grant date, there would be no built-in gain to exercise into, and had it been set below $5 the option would have been a Section 409A problem from the day it was granted.

Why the strike price is set the way it is

• Fixing the price at grant is what gives an option its value: the holder captures the growth above the strike without risking cash on the shares in the meantime.
• Pricing an incentive stock option at fair market value keeps it inside Section 422, and pricing any option at or above fair market value keeps it outside Section 409A.
• A published or appraised grant-date value gives every party the same number for the tax calculations that come later.

The traps in the strike price

• A strike set below grant-date fair market value looks like a gift and is actually a Section 409A violation, with ordinary income at vesting plus a 20% penalty and interest.
• An underwater option, where the share price has fallen below the strike, is worth nothing to exercise, and a long-vested grant can spend years that way.
• A private-company strike depends on an appraisal that is an estimate, so two valuations of the same company can differ, and a later financing can reprice the stock well above an earlier employee's strike.