How to Set an Exercise Price in an Option Grant
If you’re an early-stage startup founder thinking about granting stock options, one of the first terms you’ll need to set is the exercise price—also called the strike price. This is the price at which a recipient can purchase a share of stock when they exercise their option. Sounds simple enough, right? But setting it too low can trigger serious tax consequences, and setting it too high can reduce the incentive value of the options. Here's how to get it right—especially when you’re still pre-revenue or pre-funding and not ready to pay for a formal 409A valuation.
What Is the Exercise Price?
The exercise price is the price your employee, advisor, or contractor will pay per share when they choose to buy their stock under the terms of the option grant. If your company grows in value, the idea is that the fair market value (FMV) of the shares will increase above the exercise price—creating upside for the optionholder.
For example:
You grant an option for 10,000 shares with an exercise price of $0.10/share.
Years later, the company sells for a price that values each share at $5.00.
The optionholder can “exercise” (buy) the shares for $1,000 and sell them for $50,000, pocketing the difference (minus taxes).
This potential for financial upside is why stock options are such a powerful tool for early-stage teams. But it only works when the exercise price is valid—and that’s where fair market value comes in.
The Exercise Price Must Equal Fair Market Value
To comply with Section 409A of the Internal Revenue Code, nonqualified stock options (which most startup option grants are) must have an exercise price that’s at least equal to the fair market value (FMV) of the common stock on the date of the grant. Otherwise, the optionholder may face immediate income tax, interest, and penalties—before they’ve even made a dime.
Founders often ask: “Can’t we just set the exercise price really low to give the team more upside?”
Absolutely not. That’s a classic rookie mistake.
If you grant an option with an exercise price below FMV, the IRS treats the difference as deferred compensation under Section 409A. That can lead to:
Immediate income tax liability for the recipient (even if they don’t exercise yet),
An additional 20% federal penalty tax,
Possible state penalty taxes, and
Interest on the underpaid taxes.
It’s a tax nightmare—and one that’s completely avoidable.
How Do You Determine Fair Market Value?
When your company is more mature—say, after raising institutional capital or generating meaningful revenue—you should get a formal 409A valuation from a qualified third-party provider. These valuations are presumed reasonable by the IRS if done correctly and give you a “safe harbor” to rely on when setting your exercise price.
But for early-stage companies, especially those with no significant funding or revenue yet, it often doesn’t make financial or strategic sense to pay thousands of dollars for a 409A valuation. So what can you do?
Reasonable Good-Faith Determinations of FMV (Pre-409A)
In the earliest stages of your company—before you’ve raised a priced round or generated revenue—you may rely on a reasonable, good-faith valuation method that’s based on your company’s facts and circumstances. Here’s how to do it in a way that stands up to scrutiny:
Document your reasoning. Include:
Incorporation date and status,
Capital raised (if any),
Revenue or lack thereof,
Intellectual property status,
Product development stage,
Market comps (if available),
Any relevant financial statements.
Use your last financing price as a reference.
If you’ve raised money on a SAFE or Convertible Note, you can’t use that valuation cap as your FMV—but you can reference the absence of a priced round to argue that your common stock has low value relative to preferred.Use a common-sense price per share.
For newly incorporated startups, a typical exercise price might be $0.0001 to $0.01 per share, based on the initial common stock purchase price by the founders. Just don’t use that price forever—once you have funding or traction, the value of your stock increases.Include a board consent approving the FMV.
Your board of directors (or you as sole director, if you're alone) should approve the FMV and document the reasoning in writing. This won’t give you 409A safe harbor, but it helps support your position if the IRS ever questions it.
When to Switch to a Formal 409A
Here are signs it’s time to move to a formal 409A valuation:
You’re issuing options regularly to new hires.
You’ve raised a priced equity round.
You have growing revenue or meaningful customer traction.
You want to minimize risk and improve your compliance hygiene.
Several startup-friendly 409A providers (e.g., Carta, Pulley, Shareworks) offer valuations starting at around $1,000–$2,000 and can often turn them around quickly.
Final Thoughts
Stock options are one of your strongest tools for attracting and retaining talent—but only if they’re done right. Set the exercise price too low, and you risk severe tax consequences. Set it too high, and you kill the incentive.
In the early days, a reasonable, well-documented good-faith FMV determination will usually suffice. But as your company grows, investing in a formal 409A is a smart step to keep your cap table clean and your team confident.
Want a checklist for issuing compliant option grants? Reach out—this is one of those legal-adjacent areas where an ounce of prevention is worth a pound of audit defense.