Strike Price

What is the strike price?

Strike price (German: Basispreis, Ausübungspreis; also exercise price) is the price per share, fixed in advance, at which an option is exercised. With a genuine employee option, the right to acquire a share in the employer later at a fixed price, the holder pays this price on acquisition. With virtual shares, which grant only a payment claim on an exit, that is, on the sale of the company or an IPO, the amount is deducted from the proceeds per share. The strike price thus determines from what company value a commitment is worth anything at all to those entitled. It acts like a hurdle: only the part of the share value that lies above it reaches the beneficiaries.

The strike price is set in the plan terms of a participation programme (ESOP) and in the individual grant. With genuine options one usually speaks of the exercise price, with virtual shares of the base price; economically both serve the same function. The term matters in three places: in designing a programme before a financing round, in due diligence and in the company sale. In due diligence, investors or buyers ask to be shown how the strike prices were derived. In a sale, the strike price helps determine the payments to the team and thus the proceeds of the shareholders.

Intrinsic value: in the money and out of the money

The intrinsic value of an option or a virtual share is the difference between the value of a share and the strike price. If the value is above the strike price, the commitment is in the money. If it equals it, it is at the money. If it is below, it is out of the money and pays nothing on an exit; the expression “under water” is also common for this. A higher strike price therefore limits participation to the increase in value above this threshold.

Formula: intrinsic value per share = value of a share minus strike price, at least zero; payment on exit = (proceeds per share minus strike price) × vested shares.

What matters is not the price that investors paid per share in the last round but the proceeds that accrue to one common share on exit. Common shares are shares without preferential rights, as held by founders. Liquidation preferences allocate part of the proceeds to the investors first. The proceeds per common share can therefore be below the arithmetic average value. This is shown by a waterfall analysis, which distributes the proceeds step by step among the share classes. A strike price equal to the last round price therefore leads to a payment only when the exit proceeds are well above the valuation of that round.

Setting the strike price

Genuine options on company shares

If the shares for an option are created by a capital increase, the exercise price must cover at least the nominal amount, that is, the amount per share fixed in the articles of association, usually EUR 1. German limited liability company (GmbH) law does not permit the issue of new shares below this amount. If the shares come from existing shareholders, the price can be agreed freely. For tax purposes, with non-tradable options no wage income arises yet on the grant but only on exercise. The taxable non-cash benefit is the difference between the value of the shares at that time and the exercise price. A low exercise price therefore increases the taxable benefit, but it does not move it into the present. How exercise and later disposal are taxed is described in the entry taxation of options.

Virtual shares

With virtual shares, the strike price is a pure calculation figure without a lower limit under company law. Four reference points are common: the value per share from the last financing round, a value with a discount that takes account of the weaker position of common shares, the nominal amount and a strike price of zero. As the strike price falls, the commitment approaches a claim to the full value per share; those entitled then also participate in the value that arose before they joined.

Many programmes graduate the strike price by the time of the grant. Someone who joins after a round with a higher valuation receives a higher strike price than early employees. In the US market, the exercise price is regularly based on an independent valuation of the common shares, because options below market value trigger tax disadvantages there. German law has no comparable requirement.

Adjusting the strike price: capital measures and down rounds

Plan terms should regulate how the number and strike price of the grants are adjusted in the event of capital measures. If the share capital is re-divided or increased from company reserves (comparable to a stock split), the number and value of the shares change without any change in company value. Without an adjustment rule, strike price and share value no longer match afterwards.

If the valuation in a financing round falls below that of the previous round (down round), grants with a higher strike price fall out of the money and lose their retention effect. Companies respond with a reduction of the strike price (repricing) or with supplementary grants at a lower strike price. Both increase the cost of the programme for the shareholders and therefore require the consents agreed for changes to the programme.

The strike price in a company sale

On an exit, the payment to those entitled results from the proceeds per share less the strike price, multiplied by the number of vested shares. Every euro of strike price thus reduces the cost of the programme for the selling shareholders. With genuine options, exercise without own funds is common (cashless exercise): exercise and sale coincide, and the exercise price is set off against the sale proceeds. Grants that are out of the money on exit generally lapse without compensation; this should be expressly regulated.

Worked example: calculating the payout at three strike prices

An employee holds 2,000 vested virtual shares. Three strike prices are compared: EUR 1 (nominal amount), EUR 40 (value with a discount) and EUR 80 (price per share of the last financing round). Each is calculated with exit proceeds per common share of EUR 120 and of EUR 70.

• Proceeds EUR 120, strike price EUR 1: (120 minus 1) × 2,000 = EUR 238,000
• Proceeds EUR 120, strike price EUR 40: (120 minus 40) × 2,000 = EUR 160,000
• Proceeds EUR 120, strike price EUR 80: (120 minus 80) × 2,000 = EUR 80,000
• Proceeds EUR 70, strike price EUR 1: (70 minus 1) × 2,000 = EUR 138,000
• Proceeds EUR 70, strike price EUR 40: (70 minus 40) × 2,000 = EUR 60,000
• Proceeds EUR 70, strike price EUR 80: out of the money, no payment

If the proceeds fall by EUR 50 per share, every payment that remains in the money falls by EUR 100,000. At the strike price of EUR 80, by contrast, the same decline decides whether anything is paid at all. The amounts are gross figures before wage tax and social security contributions.

Distinctions: strike price, exercise period and fair market value

• Exercise period: the period in which a genuine option can be exercised. The strike price determines the price, the exercise period the time.
• Fair market value: the market value of a share. It is the reference point for setting the strike price and, for genuine options, for the amount of the taxable benefit.
• Liquidation preference: determines what proceeds per common share are available on exit, and thus whether a strike price is in the money.

Common mistakes

• Grant without a strike price. A grant in percent without a strike price leaves open whether those entitled participate in the whole value or only in future growth.
• Round price without review. If the price of the preferred shares is adopted unchanged as the strike price, the grants are out of the money at moderate exit values.
• Missing adjustment rule. Without a rule for re-division and capital increase from company reserves, strike price and share value no longer match after a capital measure.
• Uniform strike price despite rising valuation. If later joiners receive the same low strike price as early employees, the programme rewards value that arose before they joined.
• Repricing without calculation. A reduction of the strike price without quantifying the additional cost leads to surprises for the shareholders on exit.

Frequently asked questions

What does strike price mean for a call option?

It is the price at which the holder of a call option may buy the underlying asset, for example a share. If the price is above it, the call is in the money; for a put option, the opposite applies. An employee option is economically a call option on shares of the employer, which, however, cannot be traded.

Do employees have to pay the strike price themselves?

With genuine options yes, on exercise; on an exit it is often set off against the sale proceeds. With virtual shares never; there the strike price is merely deducted from the payment.

How is the strike price set?

According to the plan terms, usually based on the value per share at the time of the grant, often derived from the last financing round. For genuine options on newly created company shares, the nominal amount forms the lower limit.

Is an out-of-the-money option worthless?

Not necessarily. As long as it runs, the share value can rise above the strike price before the exit. If it is out of the money at the time of the exit, however, it leads to no payment.

Does the strike price affect tax?

Yes. With genuine options, it reduces the non-cash benefit that is taxable as wage income on exercise. With virtual shares, it reduces the payout and thus the wage income at the time of payment.

Can the strike price be reduced afterwards?

Yes, by amending the grants. Because the reduction burdens the shareholders economically, the consents that the shareholders' agreement provides for changes to the programme are generally required.

The Roemer Capital view

A strike price is an understandable part of their remuneration for employees only if they can see what it means at different exit values. We therefore derive the payments per grant from the three cases of the financial model, the base case, the cautious case and the optimistic case, taking the liquidation preferences into account. This makes visible whether a strike price is in the money at all in realistic scenarios.

Before a financing round, we check whether strike prices, pool size and preferences fit together, and we coordinate changes with the company's law firm and tax advisers, who are responsible for implementation.