How to set the strike price for employee stock options

Stock options are only as useful as the price attached to them. If the exercise price, also called the strike price, is set too high, the grant has little value to the employee who receives it. If it is set below fair market value, the company and its employees can face tax consequences that undo much of the benefit the plan was meant to create.

A public company can look at its share price. A private company has to determine fair market value. That valuation depends on a series of earlier decisions: how many shares the company has, how large the option pool will be, how dilution is counted, and who determines the value. This guide covers each step in the order we recommend addressing them.

What the strike price is, and why it should equal fair market value

The strike price is the fixed price an option holder pays to buy one share when they exercise the option. If the company grows, the shares become worth more than the strike price, and the employee keeps the difference.

Standard practice is to set the strike price equal to the fair market value of a common share on the date the option is granted. In Canada, a strike price at or above fair market value is one of the conditions for the stock option deduction, which lets the employee deduct half of the benefit. In the U.S., pricing options below fair market value can create penalties for the employee under Section 409A of the Internal Revenue Code.

A strike price at fair market value gives the employee a stake in future growth without giving away value that already exists.

Step 1: make sure the company has enough shares

Some private companies are incorporated with a small number of shares, such as 100 or 1,000. That works for founders, but it makes an option plan impractical. Consider a company whose common equity is worth $3,000,000:

With 1,000 shares, a meaningful grant comes to fractions of a share at $3,000 each. It is hard to administer and hard for an employee to relate to. With 10 million shares, the same economic grant is 25,000 options at $0.30, which is easier to issue, track and explain.

A share subdivision, or stock split, does not change what the company or anyone’s stake is worth. It only changes the number of units. It should be done with corporate counsel before the plan is adopted.

Step 2: decide how dilution will be counted

Before setting a strike price, the company should decide which share count it will use and apply it consistently.

The fully diluted share count is the most complete measure of ownership. It includes:

• Issued shares
• Outstanding options and warrants
• Convertible instruments such as SAFEs and convertible notes, on an as-converted basis
• The full option pool reserve, whether or not it has been granted

Offer letters that express a grant as a percentage of the company should state which share count that percentage is based on.

The per-share value used for the strike price is a separate calculation, and the instruments included in it affect the result. Agree with your valuer which instruments are included and how, write the definition into the plan and the board materials, and apply it the same way at every grant.

Step 3: size the option pool

The option pool is the number of shares reserved for future grants. The best way to size it is from the hiring plan, not from a benchmark:

1. List the roles you expect to fill over the period the pool is meant to cover.
2. Estimate the grant each role will need.
3. Add a margin for retention grants and for roles you cannot yet foresee.

Market convention is useful as a cross-check. Pools commonly fall between 10% and 15% of the company’s equity, and 10% is the most frequent choice.

Timing matters as much as size. Investors in a priced round often ask for the pool to be created or enlarged before their investment, on a pre-money basis, so the dilution from the new pool falls on the existing shareholders rather than on the incoming investors. Founders who understand this can size the pool to the plan they will actually execute, and top it up later, rather than reserve a large pool upfront and give away more ownership than they need to.

Step 4: engage an independent professional valuation

Once the share structure and pool are settled, the company needs a supportable fair market value for its common shares. An independent valuation gives the board a documented basis for the strike price. It also gives the company a defensible position if the Canada Revenue Agency, the IRS, investors, auditors or a future acquirer review its option grants.

A valuation for option grants typically involves:

• Understanding the business: its operations, financial results and forecasts.
• Reviewing the capital structure: the cap table and the rights attached to each class of shares, including liquidation preferences, conversion terms and participation rights.
• Valuing the company as a whole: using one or more approaches, such as discounted cash flow, comparable public companies and transactions, and the price paid in a recent financing.
• Allocating that value to the common shares: usually through an option pricing method, a scenario-based approach or a current value method, depending on the company’s stage and likely exit paths.
• Applying a discount for lack of marketability: this reflects the fact that private company shares cannot easily be sold.

Because preferred shares carry rights that common shares do not, the fair market value of a common share is usually well below the price investors paid for preferred shares in the last round. Using the preferred price as the strike price overprices the options and weakens the incentive. Using an informal estimate leaves the price open to challenge.

Step 5: approve grants at the valuation price, and keep it current

Grants should be approved by the board with an exercise price no lower than the fair market value per share in the most recent valuation. Grants should not be backdated, and each grant should be recorded on the cap table and in the option ledger at the time it is made.

A valuation does not stay current indefinitely. It should be refreshed at least annually, and after any event that could change the value of the company:

• A new financing or a signed term sheet
• An acquisition offer
• The gain or loss of a major customer
• A significant change in results

Options granted on a valuation that predates one of these events may carry a strike price below fair market value.

Canadian tax considerations

How the stock option benefit is taxed depends on whether the employer is a Canadian-controlled private corporation (CCPC).

For CCPC employees, nothing is taxed when the option is granted or exercised. The benefit is taxed when the shares are eventually sold, and the employee can deduct half of it in either of two cases:

• They hold the shares for at least two years after exercise.
• The general conditions for the deduction are met, which include an exercise price at or above fair market value on the grant date.

For employees of companies that are not CCPCs, the benefit is taxed in the year of exercise. The deduction is available only if the general conditions are met: the shares are common shares, the employee deals at arm’s length with the employer, and the exercise price was not less than fair market value at grant. An annual limit of $200,000 on options eligible for the deduction applies only to non-CCPC employers with consolidated revenue above $500 million. It does not apply to CCPCs.

Tax rules change, and each company’s situation is different, so the tax treatment of a specific plan should be confirmed with the company’s tax advisor.

If the company has U.S. employees

Companies that grant options to U.S. employees, including Canadian companies with U.S. staff, also need to consider Section 409A. Options granted below fair market value can trigger the following for the employee:

• Immediate taxation of the deferred amount
• Interest on that amount
• An additional 20% tax

Incentive stock options, a U.S. option type with preferential tax treatment, must also be granted at no less than fair market value.

An independent appraisal can give the company a safe harbor. The valuation is then presumed reasonable unless the IRS can show it is grossly unreasonable. That presumption generally lasts up to 12 months from the valuation date, or until a material event occurs, whichever comes first. For more on how the two regimes interact, see 409A vs. Canadian fair market value.

Common mistakes to avoid

Most problems with strike prices come from the order in which decisions are made rather than from the valuation itself:

• Adopting a plan before the share count has been subdivided, which leaves grants in awkward fractions of a share
• Defining the share count one way in offer letters and another way in board materials
• Sizing the pool from a rule of thumb instead of a hiring plan
• Granting options on a valuation that predates a financing
• Using the price of the last preferred round as the strike price for common options

Each of these is easier to prevent at the start than to correct once options have been granted.

Frequently asked questions

What is the difference between the strike price and fair market value?

Fair market value is what a common share is worth on a given date. The strike price is the price the option holder will pay to buy a share. For most option grants, the strike price is set equal to fair market value on the grant date.

Can a private company set the strike price below fair market value?

It can, but it usually should not. In Canada, a below-market price can cost employees the stock option deduction unless the shares are CCPC shares held for at least two years. In the U.S., it can trigger penalties under Section 409A.

How often should a private company update its valuation for option grants?

At least once a year, and again after any material event such as a financing, a term sheet, an acquisition offer or a major change in results.

Do Canadian companies need a 409A valuation?

Section 409A applies to U.S. taxpayers. A Canadian company that grants options to employees who are U.S. taxpayers should have a valuation that meets 409A requirements.

Further reading

• What is a 409A valuation? A simple guide for startup founders
• 409A vs. Canadian fair market value: what founders with cross-border cap tables need to know
• Understanding liquidation preference and participation