Can You Exercise an Option when FMV is Less Than Strike Price? Should You?

A stock option is considered to be "underwater" when the fair market value (FMV) of the option (the stock price if publicly traded; the 409a price if pre-IPO) is less than the strike price of the option. If a company is not doing well (or if the overall market has repriced, which occurred in 2022), it's not uncommon for stock options granted a few years ago to now be underwater.

To the crux of the question however, if you have an underwater stock option: (1) are you allowed to exercise the options; and (2) if yes, should you?

(1) Are you allowed to exercise the options? Yes, you are allowed to exercise a stock option that is underwater. The stock option grant provides you with the right to purchased a specified number of shares at a specified price. How the FMV of the company's changes after the grant does not change this right.

(2) Should you exercise options that are underwater? Like so many things in stock-based compensation, the answer to this question is "it depends."

• If your company is publicly traded, we know of no circumstances where it makes sense to exercise an underwater stock option (as you can just go and buy those shares at a lower price on the public market)

• If your company is pre-IPO, in most circumstances it will not make sense to exercise an underwater stock option; but there can be a few circumstances where it does (especially considering that the 409a valuation of a company differs from the VC preferred valuation). For example:

  • (1) If you're leaving the company and need to exercise your vested options or let them expire, and despite the underwater nature of your options you very strongly believe in the company and believe exercising will be a good investment

  • (2) If you anticipate a liquidity event in the near future at an attractive price. For example, you have an option with a $1.00 strike price when the 409a value of the company is $0.75 (and the VC preferred value is around $3.00). There is speculation that your company may be acquired for around $5.00 per share. (note: we strongly advise against making investment decisions based on speculation; this example is provided purely for illustrative purposes)