What should be the exercise price/strike price of an Employee Stock Option?

The exercise price for a stock option will depend on the objective for which the ESOPs are being granted. ESOPs for employees can be granted based on different considerations by different companies. In fact, even with respect to different employees within the same company, the exercise price may be different, as the ESOPs may be granted to the different employees by the company with different objectives in mind. Let us elaborate on how it works.

Remuneration lower than the market level

If you are granting ESOP benefits to your employees in lieu of salary, with the objective of making up for the lost compensation for an employee who has taken a huge salary cut and joined a start-up, it is only fair that the ESOPs be granted to the employee at an exercise price which is as low as possible. Typically, that would be the par value (or the face value) of the shares. The typical face value is INR 10, though, it differs from company to company. It would be advisable to check the face value of your company’s equity shares before finalizing the exercise price.

Market level remuneration

If your employees are already drawing market level salaries and the stock options are granted to them in the form of added incentive or bonus, then the exercise price of the options should be higher.

For example, if you are granting ESOPs soon after a fundraising round, then you could use the valuation of shares assigned by the investors in such round as the benchmark. So, if you have issued shares at a price of INR 100 per share to the investors, you could fix the exercise price at INR 100 per share or maybe at a discount to the fair market value, for instance, INR 80 per share.

I often get asked, if INR 100 (i.e. issuing shares at the fair market value) to the employees would be an unfair exercise price. I honestly don’t think so, simply because the employee is not going to buy the shares immediately. The employee can only buy the shares depending on the vesting date as per the vesting schedule, which will be after a minimum period of 1 year in India (given the mandatory 1 year cliff period). By that time, hopefully the fair market value of the shares of your company would increase. Therefore, at the time of exercise date, the ESOP still benefits the employee as the exercise price would be a discount to the then fair market value of the shares of your startup.