Fair Market Value vs. Strike Price: What Is the Difference?
Grasp the financial and tax implications of stock options by learning how a fixed purchase price relates to the stock's fluctuating market value.
Employee stock options are a form of compensation that allows an individual to buy company stock at a set price. Understanding this benefit requires familiarity with two terms: fair market value and strike price. These concepts are fundamental to grasping the potential financial benefit of stock options. While they may seem similar, their distinct roles in the process determine the value and tax consequences for the recipient.
Defining Fair Market Value
Fair Market Value (FMV) represents the current price of a single share of stock on the open market. For a publicly traded company, determining the FMV is straightforward; it is the price at which the stock is trading on a public exchange, like the NASDAQ or NYSE, on any given day. This value is dynamic, fluctuating with market conditions, company performance, and broader economic factors.
Private companies must establish their FMV through a formal, independent appraisal process. This is most commonly done through a 409A valuation, named after Internal Revenue Code Section 409A. This valuation must be conducted by a qualified third-party appraiser at least once every 12 months or after a significant event, such as a new funding round or a merger. The resulting FMV is a defensible figure that ensures the company is compliant with tax laws when issuing equity.
Defining the Strike Price
The strike price, also known as the exercise or grant price, is the fixed, predetermined price at which an employee can purchase a share of the company’s stock. This price is specified in the stock option agreement provided to an employee on their grant date. Unlike the Fair Market Value, the strike price does not change over the life of the option.
To comply with tax regulations, companies must set the strike price at or above the FMV on the date the stock options are granted. This prevents the company from issuing options at a discount, which could create immediate tax consequences for the employee. Therefore, on the day an employee receives their options, the price they would pay for the stock is equal to its current market value. The potential for profit arises later, as the FMV of the company’s stock hopefully increases.
The Relationship and Financial Impact
The financial opportunity of a stock option materializes from the difference between the dynamic Fair Market Value and the fixed strike price. The potential gain is realized when an employee chooses to exercise their options, which means purchasing the shares. The value is derived from the spread between the strike price set at the grant date and the FMV at the moment of exercise. This difference is commonly referred to as the “bargain element.”
This bargain element represents the on-paper profit an employee gains per share. For instance, imagine an employee is granted options with a strike price of $10 per share. A few years later, the company has grown, and the FMV of the stock is now $50 per share. When the employee exercises their options, they still pay the original $10 strike price for each share that is now worth $50. The bargain element in this scenario is $40 per share ($50 FMV – $10 Strike Price), resulting in a significant paper gain.
How the Difference Impacts Taxation
The tax implications for an employee are directly tied to the bargain element, and the treatment varies significantly based on the type of stock option granted. The two primary types are Non-qualified Stock Options (NSOs) and Incentive Stock Options (ISOs).
For NSOs, the bargain element is taxed as ordinary income in the year the options are exercised. This amount is subject to federal and state income taxes, as well as Social Security and Medicare (FICA) taxes. The company includes this income on the employee’s Form W-2 and withholds the necessary taxes. Any subsequent increase in the stock’s value from the exercise date to the sale date is then treated as a capital gain.
ISOs receive different tax treatment. The bargain element is not subject to regular income tax at the time of exercise. Instead, it is considered an adjustment item for the Alternative Minimum Tax (AMT), a separate tax calculation that can trigger a tax liability for higher-income individuals, even if no shares are sold.
If the shares are held for more than one year after exercise and two years after the grant date (a “qualifying disposition”), the entire gain from the strike price to the final sale price is taxed at more favorable long-term capital gains rates. If these holding periods are not met, the sale is a “disqualifying disposition,” and the bargain element is taxed as ordinary income, similar to an NSO.