Determining the exercise price of a stock option

Exercise price or strike price is the price at which the holder of stock options has the right, but not the obligation, to purchase vested options within the term period. 

ESOPs that have vested can be exercised. To do this, the employee has to reach out to the CHRO or the finance team, and initiate the process of exercising ESOPs. Note that the employee has to pay a tax while exercising ESOPs, and only after that he/she will receive the shares and then may choose to sell.

The strike price of options can be anything that is chosen by the company while giving out the ESOP grant letter. Some startups choose the exercise price as a nominal amount (say INR 10) while some startups choose the exercise price based upon the last round valuation of the company. 

In the latter case, the difference in the company’s valuations between when the employee joined and the liquidity event in which he/she sells ESOPs, represents the money gained by the employee.

While there is no concrete formula to arrive at the ideal exercise price, we suggest founders set the exercise price at a nominal value (face value of shares at minimum). There are two advantages of a nominal exercise price: 

• Employee-friendly: Employees won’t have to pay a larger value for exercising their ESOPs
• Independent of Valuation: If the valuation of the startup goes down significantly, employees might end up losing money from the ESOPs they would have exercised

Let’s say the exercise price of ESOPs as per the last round valuation of the company is INR 80, and the employee was offered 100 ESOPs at an exercise price of INR 70. The company went on to raise another round of funding 3 years after ESOPs were granted to this particular employee. Assuming that the valuation of the company has gone down and the FMV of shares is INR 65 now, the employee will make a loss of INR 5 per share if he/she exercises and sells the shares on the present day.    

Now if the employee was granted ESOPs at a nominal exercise price of INR 10 each, the employee will make some money despite the decreased valuation.