The strike price is fixed at grant, and that is the entire economics of an option.

Strike price and exercise price are the same thing

A stock option gives its holder the right to buy a fixed number of shares at a fixed per-share price. That price is the strike price; plan documents and grant notices more often call it the exercise price. The two terms are interchangeable in employee equity. The same word is used for exchange-traded options, where the strike is the price at which a listed contract can be exercised against an anonymous counterparty — related mechanics, entirely different context, and not what this page is about.

The defining feature of the strike price is that it does not move. It is fixed on the grant date and stays there for the whole term of the option, while the company underneath it is revalued repeatedly. Everything an option is economically — the leverage, the upside, the ability to go underwater — comes from that one fact. If the strike floated with the company value, an option would be worth nothing at all times.

How the strike price is set

The board sets the strike at or above the fair market value of the common stock on the date of grant. This is not a convention; it is a requirement pulling in from two directions. For an incentive stock option, IRC §422(b)(4) mandates an exercise price of at least fair market value at grant, and §422(c)(5) raises that to 110% with a five-year maximum term for a holder of more than 10% of voting power. For any option, granting at or above fair market value with a fixed share count and no additional deferral feature is what makes the option exempt from §409A under Treas. Reg. §1.409A-1(b)(5)(i).

Falling inside §409A is the failure mode that matters, because the penalty falls on the recipient rather than on the company that made the mistake. A discounted option is treated as nonqualified deferred compensation: the amount is included in income as it vests, with an additional 20% tax and a premium interest charge under §409A(a)(1)(B). An employee who was handed a below-market strike as a favour ends up with a tax bill and no cash to pay it. This is why boards do not price grants informally, and why a valuation is refreshed before a grant round.

The 409A valuation and its safe harbours

A private company has no market price to point at, so it buys an appraisal. Treas. Reg. §1.409A-1(b)(5)(iv)(B) sets out methods that create a presumption of reasonableness for the resulting fair market value. The most common is an independent appraisal as of a date no more than 12 months before the grant. Where a safe harbour applies, the IRS can only displace the valuation by showing it was grossly unreasonable — which is the entire commercial reason companies pay for the appraisal rather than estimating.

The phrase doing the most work is "material event". A valuation is a photograph of a company on one date, and the presumption depends on nothing significant having happened since. In practice that means closing a priced round, signing a term sheet, losing or landing a customer large enough to move the business, receiving an acquisition offer, or any comparable change in the facts an appraiser relied on. Closing a round is the classic trigger: the company is demonstrably worth something different from the day before, and the new 409A follows.

Why the 409A price is lower than the preferred price

This is the single most misunderstood number in employee equity. A company raises at $10.00 per share and issues option grants with a $2.50 strike, and it looks as though someone is being told their shares are worth a quarter of what investors just paid. Nothing improper is happening. The two numbers are prices for two different securities.

Investors bought preferred stock. Preferred carries a liquidation preference — a right to be paid first, and often a specified multiple, before common receives anything — and frequently carries protective provisions, board rights, anti-dilution protection, and registration rights. Common stock has none of that. It is the residual claim: last in line, with no downside protection. An appraiser allocates the enterprise value implied by the round across the classes according to their respective rights, and common necessarily receives less per share than preferred because it is entitled to less.

On top of the allocation, common stock in a private company cannot be sold. There is no exchange, transfers usually need board consent, and a holder may wait years for any liquidity at all. Appraisers apply a discount for lack of marketability to reflect that. Allocation plus marketability discount is why a common share is appraised well below the preferred price, and it is the reason a low strike is good news for a grantee rather than a signal that the company is worth less than it claims.

The spread, and what it costs

The spread is fair market value on the exercise date minus the strike price, per share. Economically it is the paper gain the option has accumulated. For tax it depends on the option type. Exercising a nonstatutory option makes the spread ordinary income under §83(a) and Treas. Reg. §1.83-7 — wages for an employee, subject to income tax and FICA withholding. Exercising an incentive stock option triggers no regular income tax, but the spread is an alternative minimum tax adjustment item in the year of exercise under §56(b)(3), reported on Form 6251. Whether that produces an actual AMT bill is fact-specific and turns on the rest of the return.

A worked example with round numbers. Someone holds 10,000 vested options at a $1.00 strike. The latest 409A values common at $4.00. The spread is $3.00 per share, so $30,000 of paper spread across the grant. Exercising every share costs $10,000 in cash — 10,000 multiplied by the $1.00 strike — and that is the only amount that leaves their bank account to buy the shares. Separately, $30,000 is either ordinary income now (nonstatutory) or an AMT adjustment (incentive), so the tax exposure sits on top of the $10,000 and is not funded by anything, because the shares cannot be sold.

Underwater options

An option is underwater when its strike price is above the current fair market value of the stock. Exercising would mean paying more than the shares are appraised at, so nobody rationally does it. It happens for ordinary reasons: a down round repriced the company, comparable public multiples fell and dragged the appraisal with them, or the business simply did not grow into the last valuation.

The usual right answer is to do nothing. An underwater option is not void and has not expired. It still has time value for as long as the term runs, and a recovery in the company's value restores the spread without any action by the holder. The two things that do need attention are the expiration date and the post-termination exercise period, because both convert “underwater today” into “gone permanently” if they pass. Someone leaving with underwater options usually loses nothing by letting them lapse; someone staying usually loses nothing by waiting.

Repricing

Repricing means lowering the strike on outstanding options so that they are back in the money. Boards do it to retain people whose entire equity package has become decoration. The structures are variations on a theme: amend the existing grants to a lower exercise price, or cancel them and issue new grants at the current fair market value, sometimes for fewer shares or in exchange for restricted stock units. Whichever route is used, the new price has to be at or above the current 409A fair market value — repricing is not permission to grant at a discount.

The tax consequence for incentive stock options is the one that surprises people. Under IRC §424(h) a modification of an option is treated as the grant of a new option. That resets the clock: the two-year-from-grant holding period for a qualifying disposition starts again from the modification date, so a holder who was months away from long-term treatment is back at the beginning. It also re-tests the §422(d) $100,000 limit — the aggregate fair market value, measured at grant, of stock for which incentive stock options become exercisable for the first time in a calendar year — and the excess over that limit is treated as a nonstatutory option.

There are two further costs. Accounting: a repricing is a modification under FASB ASC Topic 718, and the incremental fair value it creates is additional compensation expense the company has to recognise. Governance: existing shareholders frequently object, and reasonably so. A repricing restores management and employee upside after a fall in value without repricing anything the investors or common holders already hold. That is why repricings are typically board-and-shareholder events with real negotiation attached, not administrative fixes.

Early exercise and the 83(b) election

Some plans allow options to be exercised before they vest. Doing so converts the option into restricted stock — actual shares, subject to the company's right to repurchase the unvested portion at cost if the holder leaves. The attraction is that the spread is measured at exercise, which for a very early employee may be zero or close to it, and the capital-gains holding period starts immediately rather than at vesting.

The structure only works with an IRC §83(b) election, filed with the IRS no later than 30 days after the date of transfer under §83(b)(2). The election tells the IRS to tax the property now, at the current spread, instead of as the repurchase right lapses. There is no statutory cure for missing the window — no extension, no late filing — and Rev. Proc. 2012-29 contains a sample form. Two things need saying plainly: early exercise means paying cash today for shares that may end up worth nothing and cannot be sold in the meantime, and the tax paid on an 83(b) election is not refundable if the company fails.