A startup grants options at a strike price. If that strike price is below the fair market value of the common stock on the grant date, two separate problems follow: a tax problem for the employees under Section 409A, and an accounting problem for the company that surfaces later as “cheap stock” in an audit or IPO review.
Both are avoidable with an independent valuation obtained on a reasonable cadence. Neither is easy to fix retroactively.
General information about valuation practice, not tax advice. Coordinate with your counsel and tax advisor.
The 409A problem
Section 409A governs nonqualified deferred compensation. Stock options granted with an exercise price below fair market value on the grant date are treated as deferred compensation, and if the arrangement does not comply, the consequences fall on the option holder: income recognition on vesting rather than exercise, an additional federal penalty tax, potential state penalties, and interest.
The employee bears this. The employee did not set the strike price. This is why underwater 409A compliance is a retention and morale issue as much as a tax issue.
Safe harbor: shifting the burden of proof
The regulations provide presumptions under which a valuation is treated as reasonable, with the IRS bearing the burden of showing it was grossly unreasonable. The most commonly used is the independent appraisal safe harbor: a valuation performed by a qualified independent appraiser, as of a date no more than 12 months before the grant, provided no material event has occurred since.
There is also an illiquid start-up presumption available in narrow circumstances, generally for companies under ten years old, without a change-of-control expectation, using a written valuation by someone with significant relevant experience.
Without a safe harbor, the company must demonstrate that its valuation method was reasonable, using the factors the regulations identify. Board-determined values with no supporting analysis are the weakest position.
What triggers a new valuation
The 12-month clock is the outer boundary, not the standard. A refresh is warranted whenever a material event occurs:
- A priced equity financing round of any size
- A convertible note or SAFE round on materially different terms
- A signed term sheet or LOI for an acquisition
- A significant secondary transaction in the company’s stock
- A major commercial milestone: regulatory approval, first large enterprise contract, key patent grant
- A major negative event: loss of a lead customer, failed trial, key departure
- A significant change in the company’s forecast or capital plan
- A material shift in the company’s public comparables or the market generally
Granting options at a stale price after a large up round is one of the most common and most expensive errors.
How the valuation is actually performed
The process has two stages: value the total equity of the company, then allocate that value across the capital structure to arrive at the common stock value.
Stage one: enterprise and equity value
Market approach, backsolve method. Where there has been a recent arm’s-length financing, the transaction price of the preferred stock is used to solve for the total equity value implied by that price, given the rights of each class. This is usually the most reliable evidence available and dominates where the round is recent.
Market approach, guideline companies and transactions. Revenue or earnings multiples from comparable public companies or M&A transactions, adjusted for stage, growth, and scale.
Income approach, discounted cash flow. More useful as the company matures and forecasts become supportable. For pre-revenue companies it is often less reliable than the market approach, though it may be used as a cross-check.
Asset or cost approach. Generally a floor, relevant mainly for very early stage or asset-holding entities.
Stage two: allocation to common
This is what distinguishes a 409A from an ordinary valuation. Preferred stock typically carries liquidation preferences, participation rights, conversion features, and sometimes dividends. Common stock sits behind all of it. Allocating requires a model that reflects those rights.
Option pricing method (OPM). Treats each class as a call option on total equity value, with strike prices at the breakpoints where economics change. Standard where the exit timing and form are uncertain, which describes most private companies.
Probability-weighted expected return method (PWERM). Models discrete exit scenarios: IPO, acquisition at various prices, dissolution. Each scenario is assigned a probability, common value is computed in each, and results are weighted. Preferred where an exit is reasonably foreseeable and its likely forms can be described.
Hybrid method. PWERM for near-term identifiable scenarios, OPM for the residual “stay private” branch. Increasingly common for later-stage companies.
Current value method. Allocates as if the company liquidated today. Appropriate only in narrow cases, such as an imminent dissolution or a company with no realistic upside beyond the preference stack.
The marketability discount
The resulting common value is then discounted for lack of marketability, reflecting the inability to sell private shares. Magnitude is informed by expected time to liquidity, volatility, and the presence of any secondary market, typically supported using option-based models.
The cheap stock problem in an IPO
When a company files to go public, auditors and the SEC staff look back at the option grants in the preceding periods. If the strike prices are well below the eventual IPO price and the valuation trail is thin, the company may be required to record additional stock-based compensation expense, restate results, and explain the gap in its filing.
The remedy is boring and effective: contemporaneous, independent valuations at every material event, with retained documentation, so the value progression from seed to IPO can be explained by events rather than hindsight.
Practical guidance for founders
- Get the first 409A before you grant the first option, not after.
- Refresh after every priced round, and on the 12-month cadence between rounds.
- Use an independent appraiser. Your investors’ preferences, your board’s judgment, and your own optimism are not safe harbor.
- Give the appraiser the real forecast, including the downside case. A conclusion supported by a forecast you never believed will not withstand review.
- Do not grant on stale valuations while a term sheet is circulating. A signed LOI is a material event even before closing.
- Keep the cap table clean. SAFEs, notes with varying caps and discounts, and side letters all affect the allocation, and reconstructing them later is expensive.
- Do not conflate the 409A common value with the preferred price. The gap between them is normal, expected, and the entire point of the allocation exercise.
FAQ
How much lower than the preferred price should common be? There is no fixed ratio and any appraiser quoting one is guessing. The gap depends on the preference stack, expected time to exit, volatility, and the allocation method. It typically narrows as a company matures toward liquidity.
Can our board just set the price? It can, but without a safe harbor the company bears the burden of proving reasonableness, and the tax consequences of getting it wrong fall on employees.
Do we need a 409A if we only issue restricted stock? Restricted stock is outside 409A in most structures, but valuation still matters for 83(b) elections, financial reporting, and later cheap stock review.
What happens if we granted below FMV already? There are correction procedures with strict conditions and deadlines. Raise it with tax counsel promptly; the options narrow with time.
