Stock Options Strike Price vs. 409a Valuation - How Do They Correlate?

For founders seeking to determine how much to price workers for shares in the firm, a 409A valuation is a must. Using a 409A valuation is the only way for a privately held company to provide workers with tax-free choices. The strike price you arrive at has repercussions, especially regarding stock options, taxes, and audits, so you must be sure you're receiving an objectively correct assessment. This article will help you understand the factors that set strike prices and learn what your company's worth may disclose. You will also see the 409a valuation impact on stock options and how their value evolves.

What do You need to Know About Stock Options Strike Price?

Your stock options grant entitles you to purchase a specified number of shares at the firm for a strike price determined at the time of issuance. The company's Fair Market Value (FMV) of a stock fluctuates over time, but your strike price does not alter. You profit when the strike price is lower than the selling price of the shares you exercise. Often, the FMV is used as the floor for pricing options. Also, a high strike price makes it challenging for employees and other members to make money when they exercise and sell their options. This is why the fair market value of a company's common stock must be defined to establish a reasonable strike price for options.

What Exactly is 409a Valuation?

In the startup world, there are two primary valuation methods. It can be either the pre-money valuation or post-money valuation. Next, when issuing stock options to workers, the founder must have a 409A valuation completed by a verified independent third party. A third-party appraiser determines the fair market value (FMV) in a 409a valuation. In most cases, the startup will cover the expenses for these analyses before employing the results to set an internal stock purchase price.?

Why is a 409 Valuation Important For a Startup?

Employees are affected in two ways by the 409A valuation. Firstly, this is what you use to set the strike price. When granting new options, companies generally use the 409A strike price as the minimum required by law. They are not permitted to issue options with lower strike prices. Secondly, the valuation will affect the amount of taxes you owe. In the event of an option exercise, the amount between the strike price and the applicable 409A will be subject to taxation.?

For example, you have options with a strike price of $2 and a 409a valuation of $2. Since the two values are the same, you will not be taxed when you exercise (granted that you have permission from your employer to exercise early). Nevertheless, if you wait to exercise until the value increases to $5, you'll be taxed on the difference of $3 for each share you redeem.

How Do the Strike Prices of Stock Options Correlate With the 409a Valuation?

Section 409A of the IRS Code states that once the strike rate of a stock option is equal to or greater than the fair market value on the day of the grant, the stock option is considered non-qualified deferred compensation. Deferred compensation is only taxable to the employee once received, and the employer is exempt from withholding requirements.

Stock options are subject to stringent requirements under Section 409A to ensure they qualify as deferred compensation. If the 409A criteria are not strictly adhered to, employees may have their options treated as taxable remuneration rather than deferred pay, resulting in a hefty income tax liability.

Significantly, the IRS may consider employee options taxable if the strike price is too low for the agency to conclude that it represents FMV. Hence, the employee and the company would know their respective tax and withholding responsibilities.

The Importance of Strike Price?

The employees may find out when they can put their stock options to use by looking at the "exercise window" specified in their option grant. If the firm allows the early exercise of options, its vesting schedule will determine when the window will open. There is a wide range of Post-Termination Exercise Periods (PTEPs), with most companies offering only a 90-day window for employees to reclaim benefits, while others are more accommodating.

If you are an employee and have stock options, it's essential to know the status of your options so you can make an informed decision about whether to exercise them between the time they vest and expire. You should also consider whether you can afford to exercise the option (including the price of exercise and any taxes that may be due upon operating), how much you value the company's potential growth, and when you anticipate being capable of trading your shares.

Summing Up

Whether you are an employer or an investor, you must carefully consider the strike price since it directly impacts the potential return on your investment. Professional advisors can help determine the right strike price for your stock options. In this case, Eqvista will be able to assist you. To figure out what your stock options' optimal strike price should be, our panel of experts can offer you accurate 409a valuation reports. Get in touch with us right away if you're interested.