What is the Exercise Price & How is it Calculated In ESOP? (2024)

The ESOP exercise price is the cost that employees pay to acquire company stock when they choose to exercise their options. It’s a sweet deal for employees who can potentially realize a profit either when the company goes public or by opting to exercise their options at a discounted rate - meaning a price lower than the market value.

The calculation of the exercise is tied to various factors - current market price, future company growth, and a sprinkle of optimism!

Let’s start from the basics.

What Is the Exercise Price in ESOPs?

Before we jump on to understanding the exercise price, we must first familiarize ourselves with the vesting period in ESOPs, as it is closely connected with the exercise price.

Simply put, the vesting period is the period over which the ESOP holder gains ownership of their ESOPs. This means that when an employee gets ESOPs from the company, they are not entitled to their ownership immediately. They can exercise these ESOPs only after a specific waiting period, commonly referred to as the vesting period.

Now coming back to the exercise price in ESOPs, it is the price at which the shareholder can purchase the share options.

Often termed the Strike price, the exercise price becomes active once the vesting period is completed.

This price is set at the stock’s fair market value at the time the stock options are granted. To acquire the stock, shareholders need to first settle the exercise price.

The scenarios in which an employee may opt to sell ESOPs include:

• If the exercise price is higher than the existing market price
• If there is uncertainty or loss of confidence with regard to the future of the company
• If there is a need to diversify the retirement portfolio by liquidating ESOP shares

But, how is the exercise period different from the vesting period?

As previously discussed, the vesting period is the duration until ESOPs become exercisable. On the other hand, the exercise period is the duration within which you have the right to exercise your ESOPs and purchase company stock.

Also, note that the true value of the ESOPs is the difference between the fixed exercise price and the current market price.

Now, you must be wondering what are the key considerations that help arrive at the exercise price of ESOPs.

Let’s find out.

Key Considerations in Determining Exercise Prices for Your ESOPs

Here are some factors you must consider while calculating the exercise price for your ESOPs.

1. Analyze Your ESOP Agreement/Grant Letter

When the company offers you ESOPs, it will also furnish a grant letter outlining the different terms and metrics.

Review the grant letter and go through the terms and conditions carefully.

What is the vesting schedule?
What are the resale restrictions?
What is the grant date of your ESOPs?

Ensure you make a note of key points like these.

Also, do your own research for different financial possibilities and implications. Simultaneously, seek clarity on the exercise period, especially in case of termination, death, or disability.

Inquire about tax responsibilities and ask the employer who is liable to pay the taxes on ESOPs - the company or the ESOP holder?

Assess the company’s growth over the years. This will give you a fair idea of how good the rate of return on the company shares will be down the line. Also, it is advisable to consult a financial advisor to get detailed information on your ESOPs and other regulatory requirements.

2. Compare the Stock’s Fair Market Value to the Current Exercise Price

Next, determine the ESOPs’ exercise price mentioned in the grant letter. Then, compare this with the stock’s current market price.

A higher exercise price when compared to the FMV indicates that your company’s stock is not performing well. On the other hand, if the exercise price is lower than the current FMV, it suggests the company’s stock is performing better and may result in profits on selling.

This exercise price must be reasonably comparable to the current market price and fit strategically within the stock market.

3. Take Legal & Regulatory Considerations Like Tax Into Account

Solely considering the exercise price and the FMV is not sufficient. You must ensure that all legal considerations are taken into account.

Taxing can come as a surprise when you set out to exercise your options. And when it's about ESOPs being taxed twice with income tax and capital gains tax, it’s all another ballgame.

For publicly traded companies, comply with relevant Securities and Exchange Commission regulations.

4. Analyze Company Financials, Performance, & Potential

Monitor your company’s financial health closely. It’s only when the company is faring well that can you expect your ESOP value to be favorable.

The value of ESOPs granted to employees is directly influenced by the company's financial success, as higher profits and increased valuation positively impact stock prices. Performance metrics, such as revenue growth and profitability, play a crucial role in determining the value of ESOP shares. Additionally, the potential for future success and expansion enhances the attractiveness of ESOPs, as employees stand to benefit from the company's upward trajectory.

Bottom Line

By now, you would have got a fair idea about what is the exercise period in ESOPs. The ESOP exercise price is just one aspect of the options dynamic. Vesting period, current market value, etc. play along with it to extract the best exercise price for an option.

Also, whether the exercise price is favorable or not depends on how well the company is performing. So yes, everything does sum up to how profitable the company is churning up or how better the company is expected to perform. In both scenarios, the company is the primary factor influencing the exercise price of ESOPs.

The exercise price must be favorable to the employees so that they feel a sense of ownership in the company, encouraging them to stay with the company for the long term.

You can enjoy a fair and visible mechanism of exercise prices and periods using a solid equity management platform such as Vega Equity. So right from accepting the grant letter, making sure it's always accessible to monitoring exercise prices and potential profit value, you can efficiently do it all via a unified platform. Contact our experts to know more.