Exercise price and strike price are interchangeable terms that both refer to the predetermined price at which stock options can be exercised to purchase company shares. In equity compensation, these terms describe the same concept: the fixed cost per share option holders pay when converting options into actual stock. Understanding these terms is essential for anyone receiving stock options.
What Are Exercise Price and Strike Price?
Exercise price establishes the economic framework for option value. The difference between the current share price and the exercise price determines whether exercising options makes financial sense. If the current share price exceeds the exercise price, the options have intrinsic value worth capturing.
Example: If you hold options with a $5.00 exercise price and the current share price is $15.00, exercising gives you $10.00 per share in immediate value. Your profit calculation is simple:
Profit per share = Current share price - Exercise price - Taxes
The exercise price remains fixed throughout the option's life, regardless of changes in company valuation. This fixed-price mechanism creates asymmetric returns: your maximum loss is limited to the cost of exercising options that decrease in value, while your potential gain has no upper limit as the company grows.
Why Two Terms Exist
Strike price originates from Wall Street trading terminology, where financial markets used "strike" to describe the price at which option holders could execute their contracts. Exercise price emerged in the 1980s and 1990s as employee equity compensation grew. Companies preferred "exercise" because it more clearly described the action employees take—exercising their right to purchase shares.
Today, both terms are fully interchangeable. Financial professionals and traders typically use "strike price," while corporate HR and legal teams favor "exercise price." Neither choice indicates anything about the options themselves.
| Feature | Exercise Price | Strike Price | Difference |
|---|---|---|---|
| Definition | Fixed conversion price | Fixed conversion price | None |
| Tax Treatment | Creates cost basis | Creates cost basis | None |
| Profit Formula | Market - Exercise | Market - Strike | None |
| Legal Standing | Binding contract term | Binding contract term | None |
How Exercise Price Is Determined
Exercise price must equal the fair market value (FMV) of company stock on the grant date. This IRS requirement prevents companies from granting options at artificially low prices that would constitute immediate compensation income.
For publicly traded companies, FMV determination is straightforward: the exercise price equals the stock's closing price on the grant date. For private companies, fair market value determination requires independent valuation using 409A valuations.
409A Valuation Overview:
- Hire independent appraiser - Select qualified valuation firm
- Provide financial data - Share financials, cap table, projections
- Analysis conducted - Appraiser uses multiple methodologies
- Report delivered - Receive formal valuation report
- Board approval - Board adopts FMV for option grants
Companies need fresh 409A valuations when significant events change their valuation: funding rounds, major revenue changes (20%+), large customer wins, or acquisition offers. The 409A result becomes the minimum exercise price for all options granted until the next valuation.
| Company Type | FMV Source | Frequency | Typical Exercise Price |
|---|---|---|---|
| Public | Stock market closing price | Daily | Previous day's close |
| Private (early) | 409A valuation | Every 12 months | Most recent valuation |
| Private (growth) | 409A valuation | After funding rounds | Post-round valuation |
Exercise Price Across Different Contexts
While the core concept remains consistent—a fixed price to acquire shares—exercise price functions differently across employee stock options, public market options, and warrants.
Employee Stock Options
Employee stock options use exercise price to determine the acquisition cost for company shares through equity compensation. This represents the most common context where individuals encounter exercise price. The exercise price directly impacts the financial benefit employees receive from their equity grants.
Exercise price creates your cost basis for tax purposes. When you exercise options at $10.00 per share and later sell at $50.00, your taxable gain is $40.00. This cost basis structure makes the exercise price critical for tax planning.
Key Characteristics:
- Vesting schedule - You can only exercise vested options
- Expiration dates - Options expire 90 days after termination
- Alternative Minimum Tax - ISO exercises may trigger AMT
- Cashless exercise - Some plans allow net settlement
- Early exercise - Some plans permit exercising unvested options
| Option Type | Exercise Price Requirement | Tax at Exercise | Typical Use |
|---|---|---|---|
| ISO | Must equal FMV at grant | No ordinary income (possible AMT) | Employee incentives |
| NSO | Usually equals FMV | Ordinary income on spread | Contractors, advisors |
Public Market and Warrant Options
Public market options use strike price to define the price at which options can be exercised on exchanges. These options have short durations (days to two years) and standardized strike prices at $2.50, $5.00, or $10.00 intervals.
Warrants function similarly to long-term call options but are issued directly by companies as part of financing deals. Warrant exercise prices typically get set 10-25% above current valuations, requiring company growth before warrants have intrinsic value. Warrants often have 5-10 year terms, much longer than public market options.
Tax Implications of Exercise Price
Exercise price determines your tax basis in acquired shares, directly impacting your eventual tax liability. The tax treatment varies dramatically between Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).
ISO Tax Treatment
ISO exercise creates cost basis without immediate ordinary income tax. If you exercise ISOs at $10.00 when FMV is $25.00, you don't pay ordinary income tax on the $15.00 spread. However, this spread becomes an Alternative Minimum Tax (AMT) preference item that may trigger AMT liability.
When you sell ISO shares more than one year after exercise and two years after grant, you pay long-term capital gains tax on the difference between sale price and exercise price. This favorable treatment requires careful AMT planning.
ISO Tax Timeline:
- Grant date - No tax impact, exercise price established
- Exercise date - No ordinary income tax, possible AMT
- Sale date (qualifying) - Long-term capital gains on full profit
- Sale date (disqualifying) - Ordinary income on spread, then capital gains
NSO Tax Treatment
NSO exercise triggers immediate ordinary income tax on the difference between exercise price and current fair market value. If you exercise NSOs at $10.00 when FMV is $25.00, you pay ordinary income tax on $15.00 per share in that year.
Your cost basis for NSOs equals the exercise price plus the amount included as ordinary income. Using the example above, your cost basis becomes $25.00 per share ($10.00 exercise price + $15.00 ordinary income), reducing your capital gains when you eventually sell.
| Tax Event | Exercise Price Role | Tax Rate | Timing |
|---|---|---|---|
| ISO Exercise | Creates AMT basis | 0% ordinary (possibly 26-28% AMT) | At exercise |
| ISO Sale (qualified) | Determines capital gain | 15-20% long-term | 1+ year after exercise |
| NSO Exercise | Determines ordinary income | 22-37% ordinary | At exercise |
| NSO Sale | Determines capital gain | 15-20% long-term | 1+ year after exercise |
Frequently Asked Questions
What is the difference between exercise price and strike price?
There is no difference. These are identical terms referring to the same concept: the fixed price at which option holders can purchase shares. Terminology choice depends on context and industry preference.
Can exercise price change after options are granted?
No, exercise price remains fixed for the option's life. The only exceptions are corporate events like stock splits that proportionally adjust all share prices. Regular company valuation changes don't affect previously granted exercise prices.
How is exercise price calculated for private company options?
Private companies use 409A valuations to determine fair market value, which becomes the exercise price. Independent appraisers analyze financial performance, market conditions, and comparables to establish compliant prices. Companies must update 409A valuations every 12 months or after material events like funding rounds.
Does exercise price affect option value?
Yes. Lower exercise prices create more valuable options by increasing the spread between exercise price and current share value. An option with a $5.00 exercise price is worth more than one with a $15.00 exercise price when shares trade at $25.00.
What happens to exercise price in a stock split?
Exercise price adjusts proportionally to maintain economic value. In a 2-for-1 split, a $10.00 exercise price becomes $5.00 while the number of option shares doubles. Total value remains unchanged.
Can companies offer options below fair market value?
No, not without immediate tax consequences. IRS regulations require exercise prices at or above FMV on the grant date. Options below FMV trigger immediate compensation income tax, negating the tax benefits of option-based compensation.
Key Takeaway
Exercise price and strike price are identical concepts representing the fixed cost to convert stock options into shares. Whether your company uses "exercise price" or "strike price," you're looking at the same number that determines your acquisition cost and tax basis. Understanding how this price interacts with your company's valuation and your personal tax situation is critical for optimizing your equity compensation strategy.