How do we determine the exercise price for stock options?

The choice of exercise prices in stock option plans is a critical one for both employees and companies. You must balance various factors to create an attractive compensation package while managing financial and tax implications. In addition to tax compliance through 409A valuation, you must also consider dilution, market trends, and the relationship between exercise prices and vesting schedules.

If you operate in multiple jurisdictions, you must understand the differences in tax laws and valuation methodologies to set a tax-compliant exercise price.

In this article, we will discuss all the major considerations in setting exercise prices for stock options. Read on to know more!

Essential factors in establishing stock option exercise prices

Some of the main considerations when setting stock option exercise prices are as follows:

409A valuations

When a private American company issues stock options to its employees and other service providers, it must get a 409A valuation to establish the company’s fair market value (FMV). A 409A valuation is simply a valuation that meets all the requirements of the Internal Revenue Code’s (IRC’s) Section 409A, which deals with the taxation of various stock-based compensations.

An employee’s taxable income from stock options depends on the difference between the FMV and the exercise price. With incentive stock options (ISOs), there is a possibility of alternative minimum tax (AMT) on exercise. However, with non-qualified stock options (NSOs), income tax is payable on exercise.

In both cases, the tax liability is calculated based on the difference between the FMV and the exercise price.

So, by keeping the exercise price as close to the FMV as possible, you can help your employees make significant tax savings. Hence, it is common practice for companies to set the exercise price based on the FMV. This allows for informed tax planning.

Market comparability

You must ensure that your stock option plans are at least as attractive as the ones being offered in your industry. This is important for companies who want to attract employees through stock options.

Competitive stock compensation is also important to retain employees for whom stock-based compensation forms a major part of their income.

Future growth potential

Your company’s growth potential is an important consideration in setting the exercise price for stock options. A company with high growth potential need not offer stock options with low exercise prices in comparison to the FMV. Such a company can easily attract employees through stock options.

The expected gains in stock price growth for a high-growth potential company may exceed any benefits coming out of discounted exercise prices and growth of low to mid-growth potential companies.

Conversely, a company with low to mid-growth potential may need to provide a significant discount.

Incentivizing mission-critical roles

At any company, the existing shareholders would like to limit dilution from stock option plans. So, you may receive board approval for a certain size of option pool and stock compensation expense. You must use this option pool and the allocation for stock compensation expenses efficiently to attract and retain mission-critical employees.

Hence, you cannot offer the same amount of stock options to every employee and it is a common practice to reserve stock options for mission-critical roles or to offer more stock options to such roles.

Another thing you could do to incentivize people in mission-critical roles is offer an exercise price with a greater discount on the FMV.

Performance-based incentives

Stock option plans can be modified to provide an additional incentive for the top performers. Traditionally, this is done by offering more stock options. However, making the most out of stock options gained by being a top performer will require the top performer to save a larger sum for exercising these stock options.

Thus, the stock options may not serve as a motivator to perform better as these additional stock options will seem un-exercisable.

A solution for such scenarios is to offer a reduced exercise price to the top performers.

Trade off with exercise period and vesting schedules

In simple terms, the attractiveness of a stock option depends on how much benefit it can provide and how soon it can provide the benefit. The potential benefit from a stock option depends on the difference between the exercise price and the FMV. To maximize your employee retention power, you may want to set a low exercise price.

Another option you have is to reduce the vesting schedule. This, too, can increase the expected return on investment (ROI) for participating employees. Let us understand this with an example.

Fracxion Quant Solutions’ shares recently received a fair market value (FMV) of $10 per share through a 409A valuation. Since Fraction Quant Solutions is a mature company, its share price is not expected to increase over the next 5 years. Hence, employee gains from stock options depend entirely on the exercise price.

In its industry, it is a norm to offer annual expected capital gains of 30% through stock options.

If Fracxion Quant Solutions crafts a stock option plan with a vesting schedule of 4 years, it must offer an exercise price of $3.50. If its board members are not comfortable with such a low exercise price, they could offer stock options at an exercise price of $4.55 and a vesting schedule of 3 years.

In both scenarios, if employees net exercised their options on the vesting date, their returns would match what they would have achieved by investing the same amount on the grant date and earning a 30% annual return.

Similarly, companies can make their stock options more attractive by increasing the exercise period. Once the exercise period ends, the stock options expire and can no longer be exercised. By extending the exercise period, you would give your employees a better chance to collect funds necessary for exercising stock options.

International compliance

If a company’s operations expand beyond borders, it must make a note of tax laws in all applicable jurisdictions where employees are granted stock options. It is possible that every country has a different set of requirements and recommended valuation methodologies for stock-based compensations.

In the US, you must get a 409A valuation every 12 months and after every material event. However, in the UK, companies must get an HMRC (Her Majesty’s Revenue and Customs Service) valuation before they get a stock option plan. Additionally, you must reach an agreement with the HMRC regarding the HMRC valuation. This agreement letter is valid for 90 days.

So, you must understand the differences in the validity of valuations in different jurisdictions when you are setting exercise prices.

Eqvista – Expert guidance for smart equity and tax strategies!

Setting the right exercise price is extremely important as it affects the potential gains and tax liabilities of the employees and expenses of the company. In this article, we reviewed various key considerations for setting exercise prices.

Since your employees’ taxable income depends on the difference between the FMV and the exercise price, basing the exercise price on the FMV can help your employees with tax planning. When you set the exercise price, you must ensure that the expected gains do not fall behind industry standards.

A high-growth company’s stock options whose exercise price is close to the FMV may be just as attractive as stock options for a low to mid-growth company with exercise prices well below the FMV.

You can also incentivize key personnel by offering a lower exercise price. Top performers can also be incentivized similarly. If you find that you cannot offer an exercise price low enough to match industry standards, consider extending the exercise period and reducing the vesting schedule.

You must also note the differences in tax laws in all jurisdictions where your employees reside.

If you need help with equity and tax planning, consider relying on Eqvista’s trusted equity and tax advisors. Contact us to know more!