The strike price for employee stock options is set when the board approves the grant. The board determines the strike price, which in most cases will be the fair market value (or “FMV”) of the company’s common stock on that day. This practice helps ensure compliance with certain federal tax rules and avoids strict penalties for both you and the company.
How is the fair market value determined?
Most of the time the board relies on a 409A valuation when determining the common stock’s FMV. A 409A valuation is a report prepared by a third-party valuation company that examines the company and its industry to determine the common stock’s value.
The fair market value is just what it sounds like – the fair value of one share of stock if it was sold on the market. Valuation firms look at several factors to determine FMV, including the company’s financial forecast, comparison to peer companies, and information about equity financings, acquisition offers or secondary sales.
A new valuation is completed at a minimum every 12 months or sooner if a major event occurs, such as getting a term sheet, completing a financing or signing a large customer contract.
After the first equity financing, isn’t the common stock just valued at a percent of the preferred stock?
Unfortunately, it’s not that simple. The 409A valuation looks at several factors, including the most recent preferred stock price per share, and no one factor is dispositive.
Companies generally don’t promise option grants with a specific strike price because a lot can affect the company’s FMV between the day of the promise and the day of the grant. While you may be able to find out what the last set of grants was priced at, this is no guarantee that your strike price will be the same or even close. Part of the risk in accepting the offer is accepting an unknown strike price. But, then again, you’re already rolling the dice by joining a startup so risk should be something you’re at least moderately comfortable with!
The good news…
Most companies try to be careful not to hire new employees before a financing or other major event. Usually, the company will wait until the new funding is received to hire new employees and issue options based on a new 409A valuation. If you’re hired directly after a financing
Also, early stage startups often move along with fairly steady growth rates and small, incremental increases to the FMV of their common stock. A huge jump in the strike price is not that likely. And if it did happen, though unfortunate, it is a great sign for the health and trajectory of the company you have an opportunity to hold shares in!
The bad news…
A company can’t always predict the types of events that trigger an increase to the common stock value, so sometimes stock grants are delayed in order to obtain a new 409A. Though unfortunate that you have to wait and possibly pay a bit more for your shares, you should take it is a good sign that the company is healthy and growing!
What can you do in this situation?
Ask the company at the negotiation stage where it is in it’s fundraising and 409A cycle. Find out how regularly the board meets and when the company expects to grant the next set of options.
If it sounds like it could be a while and you’re worried about changes to the stock’s FMV, you may be able to negotiate some concessions from the company. For example, you could ask for a larger number of shares, or a bonus or loan to cover some portion of the total exercise price.