Stock Option Savvy: Strike Price vs. Exercise Price Explained

The use of incentives has a significant impact on the provision of financial rewards and recognition of employees' efforts, often leading to the use of employee option plans as part of compensation. This plan is designed to motivate employees by providing them with equity in the company. Under such plans, employees are given the opportunity to purchase company shares at a predetermined price (usually lower than the current market price) at a specific time. Details of the present value, vesting period, and other terms are usually described in the employee option contract.

But for this article, we’ll be looking closely at the ‘exercise’ and ‘strike’ prices and clarify their differences for a better understanding.

Strike Price vs. Exercise Price: What’s the Difference?

Strike price Vs Exercise Price are often used interchangeably and often mean the same thing. However, there is a slight difference: While the "strike price" is announced when the option is given, the "exercise price" is reflected during the exercise of the option. The difference is small, especially when it comes to employee stock options, which are essentially the same.

The difference between these two terms comes into play when discussing them from an ESOP perspective and a stock options derivation perspective.

The exercise price and strike price are the same while discussing it from an ESOP perspective, but the difference arises while discussing it from a stock options perspective.

Exercise price and strike price are the same while discussing it from an ESOP perspective, but the difference arises while discussing it from a stock options perspective.

What is the Strike Price in ESOPs?

You may be curious about how your company establishes the strike price, which is the pre-set cost at which you can purchase shares. This price is not randomly selected or based on a mere guess. Instead, it is the result of a careful and thorough process that takes several factors into account. By gaining an understanding of these components, you can acquire valuable knowledge regarding your equity compensation.

1. Fair Market Value(FMV)

The strike price is determined by the fair market value of the company's shares. An external valuer (registered valuer or merchant banker) typically determines FMV by evaluating several factors, including the company's assets, liabilities, and potential profitability. Appraisers determine current market conditions and consider the price a willing buyer would pay for a stock to a willing seller.

2. Company Valuation

The strike price is often influenced by the company's overall valuation, which includes assets and revenue, and values ​​such as market value and business plan. You can generally expect higher profits to result in a higher strike price, whereas a lower strike usually translates to a lower price.

3. Historical Stock Prices

The strike price depends mainly on the overall assessment of the company, which includes not only assets and profits but also intangible elements such as reputation, property rights, and business. In general, higher market prices will lead to higher strike prices, while a company's lower investment will lead to lower prices.

4. Market Conditions

The economy, measured by economic indicators such as interest rates, inflation, and employment, can influence investors' decisions. From an investor's perspective, a strong economy will lead to greater resilience. On the other hand, a weak economy marked by negative investor sentiment will lead to falling prices.

5. Competitive Landscape

How your company performs compared to its competitors depends on factors such as market share, unique selling points, and customer loyalty, which can also affect the strike price. If your company is a leader in the industry or has a competitive advantage, this will usually result in a higher strike price

How is the Exercise Price Set?

The exercise price is similar to the strike price and is generally determined by the fair market value of the stock at the time the option is granted.

• However, some exceptions apply
• Vesting schedules
• Tax implications

These are 2 exceptions that may impact the exercise price.

Finding the difference between the terms is important, as it is often confused that both of them mean the same because of them being frequently used interchangeably.

Are Exercise Prices Negotiable?

Typically, exercise prices for options are not subject to negotiation, as they are determined based on a standard valuation of the company's shares and assets.

Consequently, deviating from the standard exercise price, whether by granting or accepting options at a different price, is infrequent and can be detrimental.

For example, accepting an exercise price lower than the established value would require the employee to pay taxes immediately on the difference. Alternatively, accepting an exercise price higher than the standard would result in paying more than necessary and sacrificing potential gains at the time of exercising.

Wrapping Up

The terms 'exercise price' and 'strike price' are frequently used as synonyms; however, there is a subtle difference between the two. The strike price is fixed at the point when the stock option is issued, while the exercise price comes into play when the employee decides to purchase the stock. Employees with stock options must understand these concepts, as the strike price significantly impacts the potential financial benefits they may gain.

The strike price is meticulously computed using a range of factors, such as the company's fair market value, valuation, historical share prices, market circumstances, and competitive landscape. Generally, employees are not expected to negotiate the exercise price, as it is established through a standard evaluation process to ensure fairness. Employees who grasp these concepts can make educated decisions concerning their stock options and maximize their potential profits.

Frequently Asked Questions