The Two Key Numbers in Every Stock Option Grant
When a startup grants stock options to an employee, two prices define the economics of that grant:
- The strike price (exercise price): The fixed price the employee will pay to purchase shares when they exercise their options. This is locked in at grant and never changes.
- The fair market value (FMV): The independently determined value of common stock on the grant date, established by the 409A appraisal.
Under IRC Section 409A, the strike price of any nonqualified stock option must be set at or above the FMV on the date of grant. The two are connected by law — but they are distinct concepts.
How Fair Market Value Is Determined
For a public company, FMV is simply the market price — look up the ticker. For a private startup, there is no public market, so FMV must be established through an independent 409A appraisal using IRS-recognised methodologies:
- Market approach (backsolve from last round, guideline public company multiples)
- Income approach (discounted cash flow analysis)
- Asset approach (net asset value, typically for pre-revenue companies)
The 409A appraiser then allocates the enterprise value to common stock using an Option Pricing Model (OPM) and applies a Discount for Lack of Marketability (DLOM). The result — the 409A FMV per common share — is the floor for your strike price.
Why the Strike Price Is Always Set Exactly at FMV
In theory, you could grant options above FMV. In practice, everyone sets the strike price exactly at the 409A FMV for two reasons:
- Employee incentive: A lower strike price means more potential gain for the employee. Setting the strike above FMV creates an "underwater" option that has no intrinsic value.
- IRS compliance: Setting below FMV triggers devastating tax consequences. Setting at exactly FMV maximises employee benefit while maintaining full compliance.
What Happens When Strike Price Is Below FMV
If the IRS determines that options were granted below FMV, the consequences apply to the employee — not the company — and they are severe:
| Tax Consequence | When It Hits | Amount |
|---|---|---|
| Ordinary income tax on spread | Year of vesting | Up to 37% federal |
| 20% federal excise tax (§409A) | Year of vesting | 20% of spread |
| State excise tax (CA, others) | Year of vesting | Up to 20% additional |
| Interest on underpayments | Accrues from vesting | Fed short-term rate + 1% |
Combined, an employee in California could face a marginal tax rate of 77%+ on the spread — payable before they can sell a single share.
The Grant Date Is the Critical Date
Section 409A evaluates the relationship between strike price and FMV at the grant date — not the exercise date or the sale date. This means:
- You cannot grant options at today's low FMV and then retroactively set a higher strike price later
- If your 409A expires before the grant date, you cannot use the old FMV — you need a new appraisal
- Board approval of the grant must occur on or before the stated grant date
- Backdating option grants to a date with a lower 409A FMV is tax fraud
ISO vs. NQSO: Does the FMV Rule Apply to Both?
Yes — both Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs) must be granted at FMV, but the consequences differ:
- ISOs below FMV: The ISO loses its qualified status and becomes an NQSO, eliminating the capital gains tax benefit on exercise. No immediate §409A excise tax but significant long-term tax cost.
- NQSOs below FMV: Full §409A consequences — immediate income tax + 20% excise tax at vesting, regardless of whether shares are sold.