Strike price, 409A and exercising options, in plain English

You are granted “48,000 options at a $0.25 strike.” Three numbers are hiding in that sentence, and the third one can cost you money you do not have yet.

The strike price

An option is the right to buy one share at a fixed price. That price — the strike, or exercise price — is set on the day the option is granted and never changes.

Your grant from part 4: 48,000 options at $0.25. If the company is later worth $10 per share, you still pay $0.25. That gap is the entire point of an option.

It also means an option can be worth nothing. If the shares end up worth $0.10, paying $0.25 for them makes no sense. Options are described as “underwater” then, which is a polite way of saying they expired worthless — a normal outcome, not a scandal.

Where $0.25 comes from: the 409A

The strike price cannot be whatever the company likes. In the US, options priced below the fair market value of common stock trigger penalty taxes for the employee under section 409A. So companies hire an independent appraiser to determine that value.

Two things founders routinely find strange:

Common stock is worth less than preferred. Your investors paid $0.6931 per share in part 3, but the 409A might value common at $0.25. That is not a trick. Preferred shares carry liquidation preferences, protective provisions and other rights that common shares do not, and those rights have value. Common being valued at roughly a quarter to a third of the last preferred price is ordinary.

It expires. A 409A supports the safe harbour for twelve months, or until something material happens — a new round, a term sheet, an acquisition approach. Grant options off a stale valuation and you have handed your employees a tax problem.

What exercising actually costs

You leave after 18 months with 18,000 vested options at a $0.25 strike, and the current 409A says common is worth $2.00.

cash to exercise   18,000 × $0.25            =  $4,500
value received     18,000 × $2.00            = $36,000
spread             18,000 × ($2.00 − $0.25)  = $31,500

You write a cheque for $4,500 and receive shares that a valuation says are worth $36,000. You cannot sell them — they are private company shares — so nothing has been turned into cash.

The bill that surprises people

That $31,500 spread is not free, and how it is taxed depends on the option type. In the US, simplified heavily:

NSOs (non-qualified options). The spread is ordinary income at the moment you exercise. You owe tax this year, on $31,500 of paper value, having received no cash.

ISOs (incentive stock options). No ordinary income tax at exercise, but the spread counts for Alternative Minimum Tax, which catches a lot of people who assumed ISOs meant “no tax.” Hold the shares long enough afterwards and any eventual gain can be taxed at long-term capital gains rates instead.

The failure mode is specific and common: someone exercises a large vested grant at a high valuation, owes tax on the spread, and the company never exits. The tax was real; the value never was. Talk to an accountant before exercising anything substantial. This is an explanation, not tax advice, and rules differ completely outside the US.

The 90-day trap

Most grants give you 90 days after leaving to exercise vested options. After that they expire.

With 18,000 vested options that is a $4,500 decision plus a possible tax bill, on a three-month clock, usually while you are between jobs. Plenty of people let options expire simply because they cannot fund the exercise in that window.

Some companies offer extended exercise windows — five or ten years — which removes the problem entirely. It costs the company nothing today and is worth far more to you than a slightly larger grant with a 90-day window.

Early exercise and 83(b)

Some plans let you exercise before vesting, buying the shares while the spread is zero or near zero, with the company keeping a right to repurchase unvested shares if you leave.

Done at grant, when strike equals fair market value, the spread is nil, so there is nothing to tax today — and filing an 83(b) election within 30 days starts the capital-gains clock immediately. It is the most tax-efficient route available to early employees, and the 30-day deadline has no extensions. Same caveat: get advice before you act.

Five questions worth asking before you accept a grant

1. How many shares, and out of what fully diluted total? A percentage means nothing without the denominator.
2. What is the strike price, and how old is the 409A behind it?
3. ISOs or NSOs?
4. What is the post-termination exercise window? 90 days or ten years is a bigger difference than 10% more options.
5. Is there acceleration on a change of control, and single or double trigger?

Every one of these has a specific answer that someone can look up in about a minute. A company that will not answer them has told you something.

Next in the series

Parts 6 to 8 cover the instruments that turn into shares later and the day they all get settled: SAFEs and convertible notes and the conversion maths, dilution across a full funding history, and the exit waterfall — who actually gets paid what when the company sells.