What it means
An option is a right, not an obligation, and the exercise price is the number that right is built around. It is also called the strike price, and the two terms are used interchangeably in almost every context.
For employees at growing companies this single number often determines whether an equity package is worth anything. Options granted at an exercise price of $2.00 when the shares later trade at $30.00 are worth a great deal, while options granted at $40.00 in the same company are worth nothing until the price recovers.
The mechanics are simple. If the market price sits above the exercise price on a call option the option is described as in the money and has intrinsic value equal to the difference, and if it sits below, the option is out of the money and holding it costs nothing but achieves nothing.
Companies generally must set the exercise price at or above the fair market value of the shares on the grant date, which is why boards commission independent valuations. Granting below that value creates accounting charges and, in many jurisdictions, unpleasant tax consequences for the very employees the grant was meant to reward.
One nuance that catches people out is that exercising costs real cash. Exercising 10,000 options at $12.00 requires $120,000 up front, plus tax in many cases, so employees holding valuable options in a private company can find themselves unable to afford the exercise before the options expire.
In practice
Real-world examples.
Example
A software engineer joins a start-up and receives 20,000 options with a $1.50 exercise price. Four years later the company is acquired at $11.00 per share, so each option carries $9.50 of intrinsic value and the engineer receives $190,000 before tax.
Example
A retail group grants senior managers options with an exercise price 15% above the current share price. The board's intention is that no value accrues unless the share price genuinely improves, rather than rewarding managers for a flat market.
Example
A commodity trader buys a call option on crude oil with a $70 exercise price when the price is $64. The option only pays if oil rises above $70, and the premium paid is lost in full if it does not.
Think of it
“Exercise price is what you pay or receive when you use your option-the transaction price.
Formula
Calculation
Intrinsic value per share (call option) = Market price - Exercise price, and total gain = Intrinsic value per share x Number of options.
An employee holds 10,000 share options with an exercise price of $12.00. The shares are now valued at $30.00 each. Intrinsic value per share is $30.00 - $12.00 = $18.00, so the total pre-tax gain is $18.00 x 10,000 = $180,000. In cash terms, the employee pays 10,000 x $12.00 = $120,000 to exercise, receives shares worth 10,000 x $30.00 = $300,000, and is $300,000 - $120,000 = $180,000 better off before tax. If the share price instead fell to $9.00, the options would be out of the money and rational holders would simply let them lapse.Case study
Seen in the real world.
Meridian Loop Systems is a fictional company created to illustrate this concept, a payments business that granted options to its first thirty employees at an exercise price of $3.20 per share. Six years later an acquirer offered $26.00 per share, giving each option $22.80 of intrinsic value.
The problem surfaced in the illustrative story when two early employees who had left the company discovered their options expired ninety days after departure. They had let them lapse rather than find the cash to exercise, forfeiting a combined amount the company later estimated at more than $400,000 of value.
The board's response was to extend the post-termination exercise window to five years for future grants and to write a plain-English summary explaining what an exercise price is and what exercising actually costs. The change did not cost the company anything in cash, and it removed the single most common complaint raised in exit interviews.
Watch out
Common mistakes.
- Confusing the exercise price with the value of the option, when the exercise price is what you pay and the value is the gap between the market price and that figure.
- Forgetting that exercising requires cash up front, which is a genuine constraint for employees holding large private-company grants.
- Assuming options are worthless because the share price is currently below the exercise price, when time remaining still gives the option value.
Questions
People also ask.
Is the exercise price the same as the strike price?
Yes, the terms are interchangeable, with strike price more common in traded options and exercise price more common in employee share plans.
Can the exercise price change after grant?
Only through a formal repricing approved by the board and usually the shareholders, which carries accounting and tax consequences and is uncommon.
What happens to the exercise price in a share split?
It is adjusted proportionally, so a two-for-one split typically halves the exercise price and doubles the number of options.
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