Meaning
Regulatory valuation standards require that the purchase price per share for employee stock options equals the cash price of the underlying stock at the time of grant. Establishing a fair market value strike price ensures that the stock option is not treated as deferred compensation under tax laws. This requirement prevents immediate taxation and penalties for the option recipient.
The strike price must reflect a realistic valuation to satisfy tax authorities.
Taxation Implication
Failure to set an accurate option price can trigger significant tax liabilities for the recipient under specific tax codes. If the fair market value strike price is set too low, the option may be deemed to have built-in gain at the time of grant. In the United States, this triggers section 409A penalties, which include immediate taxation upon vesting and a twenty percent excise tax.
This outcome harms the employee and complicates payroll reporting.
Valuation Methodology
Companies use independent appraisals to determine the correct stock value. An external valuation report, commonly known as a 409A valuation, establishes the fair market value strike price with a presumption of correctness. This process occurs at least once every twelve months or whenever a material event occurs.
Relying on an expert report protects the board from liability.
Option Exercise
The strike price directly determines the cost of option exercise. A high fair market value strike price requires the option holder to pay a larger sum to acquire the shares. This payment affects the employee’s potential gain upon a liquidity event.
