409A Valuation

What it means

A private company is not traded on a public stock exchange, so it does not have a daily price. Because the IRS requires the company to know what its stock is worth for tax reasons, it hires an expert to calculate a Fair Market Value (the price the stock would sell for on the open market).

This price, known as the 409A value, is usually lower than what big investors pay because employee stock has fewer rights. The company must refresh this valuation at least once a year or after a major business event to stay in compliance with tax laws.

A simple example

Imagine a company hires an appraiser to value its stock. The appraiser decides the Fair Market Value is $2 per share. If your company gives you stock options, your Strike Price (the price you pay to buy each share) must be at least $2. If you buy 1,000 shares, you pay $2,000. If the stock is later worth $5 per share, your Spread (the profit you make on paper) is $3 per share, or $3,000 total.

Why it matters to you

• The 409A value ensures you get a fair Strike Price, which helps keep your tax bill predictable.
• If your company sets a price lower than the 409A value, you could face heavy IRS penalties.
• It determines the Spread, which is the amount of money used to calculate your taxes when you Exercise (buy) your options.

Common mistakes to avoid

• Assuming the 409A value is the same as the price investors pay; it is often much lower.
• Forgetting that if you Exercise options when the market value is higher than your Strike Price, you may trigger taxes.

Words used on this page

• Fair Market Value: The estimated price a buyer would pay for the stock today.
• Strike Price: The fixed price you pay to buy your company stock when you use your options.
• Spread: The difference between the Fair Market Value and your Strike Price.
• Exercise: The act of using your options to purchase actual shares of company stock.