The independent appraisal that sets your strike price and anchors every tax calculation.
Section 409A of the Internal Revenue Code regulates deferred compensation. For private companies, it effectively mandates that stock options be granted at no less than the fair market value of the underlying shares, otherwise the option is treated as deferred compensation and subject to immediate income tax plus a 20% penalty on the employee. To establish that strike prices comply with this rule, companies obtain 409A valuations from independent appraisers before issuing new option grants. Internally determined valuations don't qualify for the IRS safe harbor.
Investors in private companies typically hold preferred stock with liquidation preferences, rights to get paid first in a sale or wind-down. Common stockholders (employees) get paid after preferred holders. A 409A appraiser uses methods like the Option Pricing Model (OPM) or Probability-Weighted Expected Return Method (PWERM) to estimate the value that common holders would actually receive across various exit scenarios. This results in a common stock valuation that is typically well below the preferred share price paid by investors in the last primary round, often 25–60% below at early stages, converging closer to parity as IPO approaches.
A 409A is valid for 12 months or until a material event, whichever comes first. Material events requiring a new 409A include closing a new funding round, a significant change in business prospects, or preparation for an IPO or acquisition. After a high-valuation Series B, the company must get a new 409A before granting more options, which is why grants issued shortly after a major funding round carry higher strike prices than grants made six months earlier. Rising 409A valuations don't change the strike price of existing granted options; they only affect new grants going forward.
The funding round price reflects what investors paid for preferred stock, which includes liquidation preferences and other rights. The 409A values common stock, which has lower priority in a liquidation and no special rights. The discount exists because the economic outcome for common stockholders across various exit scenarios is lower than for preferred stockholders.
No. The strike price for ISOs and NSOs must be set at or above the FMV determined by the current 409A. Setting a lower price would violate Section 409A of the tax code and expose the option holder to immediate taxation and a 20% penalty. The only legitimate lever is the timing of your grant relative to when the last 409A was conducted.
A rising 409A does not change the strike price of options you've already been granted. Those are locked in at grant. It only affects new grants. A rising 409A does mean the spread on your existing options is larger, which increases both the intrinsic value of your options and the potential AMT or ordinary income exposure when you exercise.
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