Fair Market Value & 409A Valuations
The independent appraisal that sets your strike price and determines how much you pay to exercise.
- What it determines
- Strike price for all new option grants
- Who performs it
- Qualified independent appraiser (5+ years experience)
- Validity period
- 12 months or until a material event
- Penalty for below-FMV grants
- 20% additional tax + interest (on the employee)
- Safe harbor
- Qualified appraisal shifts burden of proof to IRS
- FMV vs preferred price
- FMV is typically 20-50% of the preferred share price
What fair market value means
Fair market value is the price at which common stock would change hands between a willing buyer and a willing seller, neither under compulsion to transact, and both having reasonable knowledge of the relevant facts. For private companies, there is no public market to set this price, so the IRS requires a formal valuation process. Under IRC Section 409A, any stock option granted with a strike price below FMV is treated as deferred compensation, triggering severe tax penalties for the option holder. This is why every private company that grants options must obtain a 409A valuation.
How 409A valuations are conducted
A qualified independent appraiser (someone with at least five years of relevant experience in business valuation, investment banking, or private equity, and no financial interest in the company) determines the enterprise value of the company and then allocates value across equity classes. Three standard approaches are used. The market approach compares the company to publicly traded peers or recent comparable transactions. The income approach projects future cash flows and discounts them to present value. The asset-based approach calculates value from net assets. For early-stage startups, the most common allocation method is the Option Pricing Method (OPM), which treats each equity class as a call option with different strike prices based on liquidation preferences. A Discount for Lack of Marketability (DLOM) is then applied, typically 20-35%, reflecting that private shares cannot be freely sold on a public exchange.
Why FMV is lower than the preferred share price
The preferred share price is what venture capital investors pay per share in a funding round. FMV of common stock is almost always lower, and this is not a loophole. Common stock lacks the liquidation preferences, anti-dilution protection, and governance rights that make preferred stock more valuable. Common shareholders only receive exit proceeds after all preferred shareholders have been paid. Common shares are illiquid with no public market. And common holders bear the most downside risk in a modest exit. At early stages, common stock FMV is typically 20-25% of the preferred price. By Series C and beyond, the gap narrows to 35-50%. As a company approaches IPO, the discount shrinks because the probability of a successful exit is higher and preferred conversion becomes more likely.
Spread per share
$12.00
Paper value
$120,000
$20,000 to exercise
Discount to preferred
66.7%
common vs preferred
If valued at preferred
$420,000
vs $140,000 at 409A
Your 409A valuation of $14 is 66.7% below the $42 preferred price. This discount reflects the difference between common and preferred stock: no liquidation preferences, no anti-dilution protection, and limited marketability. Your 10,000 shares are worth $140,000 at 409A but would be $420,000 if valued at the preferred price. The exercise cost is $20,000 (14.3% of 409A value).
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Simplified comparison. Actual common stock value depends on liquidation preferences, participation rights, and the cap table waterfall. This is not investment advice.
When a new valuation is required
A 409A valuation is valid for a maximum of 12 months. It expires immediately, regardless of age, upon a 'material event' that changes the company's value. Material events include closing a new priced equity round (up or down), entering into a merger or acquisition, significant changes in financial performance or business model, secondary transactions in company stock, and beginning preparation for an IPO. Companies typically obtain a new 409A within 30 days of a material event, though no statutory deadline exists. The key rule is that options must be granted at the current FMV, so any event that materially changes the stock's value invalidates the prior appraisal.
Safe harbor protections
The IRS provides three safe harbors that create a legal presumption that the valuation is reasonable. The most common is the qualified independent appraisal: a valuation by an independent appraiser with five or more years of relevant experience, performed within 12 months of the option grant date. The illiquid startup presumption is available to companies less than 10 years old with no public securities and no anticipated change of control or IPO within the next 12 months, which allows a less expensive valuation by a qualified individual rather than a formal appraisal firm. The binding formula method requires a single, consistently applied repurchase formula for all stock transfers and is rarely used. With a safe harbor in place, the IRS must prove the valuation is unreasonable by 'clear and convincing evidence.' Without one, the company bears the burden of proof.
The penalties for getting it wrong
If options are granted below FMV, the consequences fall on the employee, not the company. All vested options become taxable income in the year of vesting (not at exercise). On top of that, a 20% additional federal penalty tax applies under IRC Section 409A(a)(1)(B)(i)(II). An interest charge at the federal underpayment rate plus one percentage point accrues from the date the compensation should have been included in income. California imposes its own additional 5% state penalty (reduced from 20% in 2013 under AB 1173). The combined impact can consume 50-70% of the option value: marginal federal income tax (up to 37%) plus the 20% federal penalty plus state income tax plus the 5% state penalty plus interest. The IRS has issued correction programs (Notices 2008-113, 2010-6, and 2010-80) for certain types of 409A failures, but prevention through proper valuation is far better than correction.
Common mistakes
Assuming your shares are worth the preferred price that investors paid. The preferred price reflects shares with superior economic rights. Thinking a higher 409A is good for you as an employee: a higher FMV means a higher strike price, which means you pay more to exercise and need a larger gain before you profit. Not understanding that the company's headline valuation divided by total shares does not equal your per-share value, because that calculation ignores the preference stack. Treating the 409A as 'just a formality' when it is a legally binding determination that directly controls your tax obligations. Not checking whether a material event has occurred since the last valuation before assuming your strike price is compliant.
Common questions
Can the company set the strike price wherever it wants?
No. Under IRC Section 409A, the strike price must be at or above the current fair market value of the common stock as determined by a qualified valuation. For ISOs, IRC Section 422 separately requires the strike price to be at least 100% of FMV (110% for 10%+ shareholders). Companies cannot arbitrarily set a low strike price to benefit employees without triggering severe tax penalties.
Why is my strike price so much lower than the latest round price?
The latest round price is the preferred share price, which reflects stock with liquidation preferences, anti-dilution protection, and other rights that common stock lacks. Your strike price is based on the fair market value of common stock, which is lower. The gap is a real economic difference, not a discount or a gift.
Does a new funding round change my strike price?
Not on options you already hold. Your existing options keep the strike price from their grant date. A new round triggers a material event that invalidates the prior 409A valuation, so any new options granted after the round will reflect the updated (likely higher) FMV. This is why early employees tend to have lower strike prices.
What if I think the 409A valuation is too high or too low?
Employees generally have no say in the 409A process. The valuation is conducted between the company and an independent appraiser. If the valuation is too low, employees benefit from a lower strike price but the company risks 409A penalties. If it is too high, employees pay more to exercise. The company has a legal obligation to use a reasonable, defensible methodology.
Providers for this path
These providers operate in the Fair Market Value & 409A Valuations space. StrikeRates does not endorse or recommend any provider. Review each independently.
Sources
This content is for educational purposes only and does not constitute tax, legal, or investment advice. Tax laws and regulations change frequently. Consult a qualified tax professional or attorney before making decisions about your equity compensation.
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