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When startups hire new senior people I understand that it is common practice to offer options, often over a period of 4 years. However, the actual value of these options will depend highly on the strike price.

Will the strike price always have to be a "fair" market value price or can it be / is it expected to be discounted? Are there tax or other reasons for why they could not be given with a 1 pound strike price even after two rounds of investment?

I am especially interested in this question in the context of the UK but also general practices.

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As much as I understand there is no hard and fast rule as to what the strike price should be. Its an arbitrary price determined by the company owners based on what they see the value would be in few years and how much cheap they need to give, and would the difference be the normal bouns they would give if they had money.

If there are few rounds of investments, then normally the investors have a clause that says that the shares cannot be given to anyone below the price at which they invested.

From a tax point of view, the cost basis is treated as the fair value and the difference in the strike price and fair value would be taxed in general apart from the gains when sold in market. Not sure about UK specific laws.

Edit:
Some links on this, although the section does not explictly say a Startup, but mentions Private company.

http://uk.practicallaw.com/9-107-4444#a574116

See section Unapproved share option schemes
Quote
These discretionary share option schemes are similar to CSOPs, but do not have any statutory requirements regarding the company, the shares, the employee or the limits on participation. They are therefore much more flexible than CSOPs, and are used by many companies in addition to a CSOP (to grant options above the limits on participation in a CSOP) or as an alternative, where the company or the individual does not qualify for CSOPs.

Many private companies which do not qualify to grant CSOPs use unapproved share options to incentivise employees to work towards an exit (eg a sale or listing) and private company unapproved options are often only exercisable on an exit. In listed companies, unapproved option exercise terms often mirror those for CSOPs, and are generally exercisable after the third anniversary of the date of grant, unless there is a corporate transaction or the option holder leaves the company for a "good leaver" reason.
UNQUOTE
As the website is UK based, this may be relevant for UK. I have not verified it.

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  • Actually, I believe there are rules, and they're quite complex. It depends, also, on the regulations of the taxing authority. While the US IRS is somewhat lenient if the strike price is within reason (i.e.: based on the latest valuation), I know of other countries where the tax authority can give you hell.
    – littleadv
    Nov 1, 2013 at 7:43
  • @littleadv: Looks like I am wrong. I though the Tax authorities are more concered on the tax aspect. IE if the strike price less than Fair Value, they would see this as additional perk in hands of employee and hence would have rules as to how the tax should be computed, rather than the strike price itself. Quite a few CEO's in listed companies get Options[Shares] at NIL price as part of the pay package. But they are taxed differently.
    – Dheer
    Nov 1, 2013 at 8:04
  • the thing is that since the company is not publicly traded - the definition of FMV is not really clear. So I know of cases where people working for startups in Israel got hit with huge taxes for their out-of-money options because the taxing authority decided that the FMV is much higher than the company declared. And go prove them wrong.
    – littleadv
    Nov 1, 2013 at 8:06

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