409A Valuation Services

When does our company need a 409A valuation?

Before the first stock option grant, at least every 12 months while you keep granting, and again whenever something material changes the value of the company.

Section 409A generally treats a stock option as deferred compensation if its exercise price is, or could become, less than the fair market value of the underlying stock on the grant date. For a private company, that fair market value has to come from the reasonable application of a reasonable valuation method. The valuation therefore needs to exist before the board approves the first grant, not after. The same rule reaches stock appreciation rights.

A valuation does not last indefinitely. Under the regulations, a value calculated as of a date more than 12 months before it is used is not reasonable — and neither is a value that ignores later information that may materially affect the company. The usual triggers are a priced financing round (including the conversion of SAFEs or convertible notes), an acquisition offer or letter of intent, a secondary sale of common stock, and a sharp change in results or forecast.

Fair market value matters beyond options. Founders and early employees who buy restricted stock, or exercise early, measure their taxable income under Section 83 against fair market value, which is why the same number sits behind an 83(b) election.

What happens if the strike price is below fair market value?

The option becomes deferred compensation under Section 409A, and the tax consequences land on the employee — before anything is exercised or sold.

An option priced below fair market value on the grant date loses the exclusion that normally keeps stock options outside Section 409A. A typical option can be exercised whenever the holder chooses, which does not meet 409A’s rules on fixed payment timing, so the option fails. Under IRC §409A(a)(1), the holder must then include the vested amount in income — in practice, the spread on the option as it vests, even though no shares have been bought and nothing has been sold.

Two further charges follow. The holder’s federal tax for the year increases by an additional 20% of the amount included, plus premium interest at the IRS underpayment rate plus one percentage point, computed as if the income had been taxed when first deferred or, if later, when it vested. California imposes its own additional tax on top of the federal one. The company, for its part, has reporting and withholding obligations on income it should have treated as wages.

Incentive stock options follow a parallel rule. An ISO must be granted at no less than fair market value — at least 110% for a holder of more than 10% of the voting power. An option that misses the mark generally loses ISO status, becomes a nonqualified option, and brings Section 409A back into play.

What gives a 409A valuation safe harbor status?

Three valuation methods earn a presumption of reasonableness that the IRS can overcome only by showing the method, or how it was applied, was grossly unreasonable.

The three are set out in Treas. Reg. §1.409A-1(b)(5)(iv)(B). The first is an independent appraisal that meets the requirements of Section 401(a)(28)(C), as of a date no more than 12 months before the grant it supports. The second is a formula price that would count as fair market value under the nonlapse-restriction rules of §1.83-5 — but only if the company values that class of stock the same way for every transfer back to the company or to an owner of more than 10% of the voting power, other than an arm’s-length sale of substantially all of the company.

The third covers illiquid stock of a start-up: a valuation made reasonably and in good faith and evidenced by a written report that takes the regulation’s valuation factors into account. It is available only if the company has no material trade or business that it, or a predecessor, has conducted for 10 years or more; has no class of equity traded on an established securities market; and its stock is not subject to a put, call or other purchase right or obligation, apart from a third-party right of first refusal or a lapse restriction. It does not apply if a change in control is reasonably anticipated within 90 days, or a public offering within 180 days, after the grant. The person performing it must be qualified through significant knowledge, experience, education or training — generally at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending or comparable work in the company’s industry.

Our 409A reports are prepared as independent appraisals under the first of these methods, so a grant made within 12 months of the valuation date can rely on that presumption, provided nothing material has changed since. A valuation outside the presumptions can still be reasonable; the difference is who carries the burden if the IRS asks.

How is the fair market value of common stock determined?

Value the company, allocate that value across preferred and common stock, then adjust the common for the fact that it cannot readily be sold.

Equity value comes from one or more of three approaches. The market approach looks at comparable public companies and transactions — and, after a recent priced round, often uses the backsolve method, which solves for the equity value implied by the price investors just paid for preferred stock. The income approach discounts forecast cash flows. The asset approach, built on adjusted net assets, fits very early companies and holding entities.

Allocation is where most of the judgment sits. Preferred stock carries liquidation preferences, conversion rights and sometimes participation — the terms negotiated in the investment documents — so a share of common is worth less than a share of preferred. The option-pricing method (OPM) models each class as a call option on the company’s equity. The probability-weighted expected return method (PWERM) weighs specific exit scenarios such as a sale, an IPO or a wind-down. A hybrid method combines the two. A discount for lack of marketability is then applied to the common, supported by put-option models and empirical studies.

The framework that preparers, auditors and valuation specialists work from is the AICPA Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. The AICPA is currently revising the guide and has published a working draft of the update, so practice continues to evolve.

How does the 409A value carry into our ASC 718 stock compensation expense?

The common stock value in the 409A report becomes the current share price input to the option-pricing model that measures stock compensation expense.

ASC 718 measures each equity award at its grant-date fair value and recognizes that amount as expense over the service period. For an option, fair value comes from a model such as Black-Scholes-Merton or a lattice model. Its inputs are the current price of the underlying share, the exercise price, expected term, expected volatility, the risk-free rate and expected dividends. For a private company, the share price is the hardest of those inputs to support.

FASB addressed that in ASU 2021-07. A nonpublic entity may elect, as a practical expedient, to use a value determined by the reasonable application of a reasonable valuation method — the 409A standard — as the current share price for equity-classified awards. The election is made measurement date by measurement date and must be disclosed. One valuation can then serve both the tax return and the financial statements.

If an IPO is in view, the SEC staff commonly questions the fair value of grants made in the period before the offering, often called cheap stock. A consistent record of valuations made at each grant date is the strongest answer.

What do you need from us, and what do we deliver?

Five sets of documents from you; in return, a written report concluding on the fair market value per share of common stock as of the valuation date.

We start with the fully diluted capitalization table — common stock, each series of preferred, options and warrants outstanding, the remaining pool, and any SAFEs or convertible notes. We then need the certificate of incorporation with the preferred stock terms; historical financial statements with year-to-date results; the forecast or budget behind the business plan; and the documents from recent financings, including term sheets, stock purchase agreements and any secondary sales.

Context matters as much as documents: the stage of the product, key customers and milestones, cash runway, and management’s view of the likely exit and its timing. The report sets out the methods, assumptions and allocation behind the conclusion, so the board can rely on it when approving grants and your auditor can trace it into the ASC 718 calculation.

We are a Korean founder or a Korean group — what is different for us?

The rules are the same, but the company granting equity is often not where the business operates, and the value has to work in two reporting systems.

After a flip to a Delaware parent, the Delaware corporation owns the Korean operating company and grants options over its own common stock. The valuation therefore looks through to the Korean subsidiary — its won-denominated financial statements, forecast and financing history. U.S. hires holding those options are subject to Section 409A, while employees of the Korean subsidiary are taxed on their gains under Korean rules. The flip also carries its own U.S. tax planning points, including qualified small business stock.

A different case is the U.S. subsidiary of a Korean group. If a parent listed on KOSPI or KOSDAQ grants its own shares, the exchange price generally sets fair market value and an appraisal is not the question. An appraisal comes in when the equity is in an unlisted entity — the U.S. subsidiary itself, a spun-out venture, or an unlisted parent. The parent’s consolidated statements then measure the same awards under K-IFRS 1102, Korea’s version of IFRS 2, so the grant-date value matters in Seoul too. We walk the parent’s finance team through the report in Korean.