409A valuation: why the strike price needs an appraisal

A 409A valuation is an independent appraisal of the fair market value of a private company’s common stock, used to set the exercise price of employee stock options. It takes its name from the section of the United States tax code governing deferred compensation, which treats an option granted below fair market value as deferred compensation with unfavourable consequences.

The reason companies take it seriously is who bears those consequences. If a strike price is later found to have been below fair market value, the penalties fall primarily on the option holder — immediate taxation on vesting rather than at exercise, plus an additional tax and interest. Employees who accepted options as part of their compensation discover a liability created by a decision the company made.

What a 409A valuation is for

• Establishing the common stock fair market value as at a date, which becomes the minimum strike price for grants made against it.
• Creating a presumption of reasonableness — a safe harbour — where the appraisal is performed by a qualified independent party using an acceptable method.
• Documenting the board’s basis for approving grants at that price.
• Supporting the treatment of grants in the financial statements and in any later audit.

When it has to be refreshed

A valuation is generally treated as supportable for up to twelve months, and it stops being reliable earlier if something material happens — a priced round, a significant acquisition offer, a large customer win or loss, a change in the business model. Companies that grant options between a stale valuation and a completed round are in the position the rules are designed to catch. The practical discipline is to refresh annually as a matter of routine and immediately after any financing, and to pause grants in the window where a material event has occurred but the new valuation has not arrived.

The preferred price in a round is not the common stock value. Preferred shares carry liquidation preferences and other rights that common shares do not, and the whole point of the appraisal is to determine what the common is worth given those rights. Setting a strike at the preferred price is expensive for the company and unnecessary for employees.

Board approval is part of the record

The valuation on its own does not set anything. Grants are approved by the board, at a stated price, on a stated date, by reference to a valuation the board has actually seen. The recurring failure is a grant promised in an offer letter months before the board consent that authorises it, which creates an argument about the grant date and therefore about the correct strike. Approve grants on a regular cadence, reference the valuation in the consent, and issue the grant documents promptly afterwards.

Keeping the file

What matters later is the chain: the valuation report, the board consent referencing it, the grant notices issued under it, and the dates connecting them. Ettex Records holds that per valuation period with the expiry date visible, Ettex Docs keeps the consents with version history, and the ownership record the grants feed into is covered in cap table.

Plainly: this is a records file, not a valuation service, and none of it is tax or legal advice. The appraisal must come from a qualified independent provider, and the consequences of getting it wrong fall on individuals rather than only on the company.