Valuation

409A valuation

Also called 409a, fair market value appraisal

A 409A valuation is an independent appraisal of a private company's common stock, used to set the strike price on employee options so the company and its employees are not penalised by US tax authorities.

Why companies need one

Section 409A of the US Internal Revenue Code requires that stock options be granted at or above the fair market value of the common stock on the grant date. Grant below that value and the option holder can face immediate income tax on the discount plus a 20% penalty, before they have sold anything.

An independent appraisal gives the board a defensible basis for the strike price. Follow the process and the burden shifts: the IRS must show the valuation was grossly unreasonable rather than the company having to prove it was right.

Why it is lower than your round price

A 409A values common stock. Investors buy preferred stock, which carries a liquidation preference, and often anti-dilution and control rights on top. Common stock is worth less because it sits behind all of that.

The gap is usually substantial at early stage. Common frequently appraises somewhere between a quarter and a half of the preferred price shortly after a round, narrowing as the company matures and an exit looks more likely.

Valuations are refreshed at least every twelve months, and sooner after any material event: a new priced round, an acquisition offer, or a significant change in the business.

Worked example

A company closes a Series A at $4.00 per preferred share.
Its 409A appraisal values common stock at $1.20, reflecting the preference and control rights sitting above it.
Employee options are granted with a $1.20 strike, not $4.00.
An employee exercising after the shares reach $10.00 pays $1.20 and holds stock worth $10.00.

Common questions

How often is a 409A valuation required?

At least once every twelve months, and again after any material event such as a priced round, an acquisition approach, or a substantial change in the business.

Why is the 409A price lower than the price investors paid?

Investors buy preferred stock carrying a liquidation preference and control rights. A 409A values common stock, which ranks behind all of that and is therefore worth less.

What happens if options are granted below fair market value?

The holder can owe income tax on the discount at vesting plus a 20% federal penalty, potentially before selling any shares. This is why boards rely on an independent appraisal.

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