What a 409A Valuation Means for Employees Holding Private Company Options

The number that sets your strike price is produced by a process most employees never see. Here is what it is, why it moves, and why it is not the same as what your shares are worth.

If you hold options at a private company, your strike price was almost certainly set by a 409A valuation. The term comes from Section 409A of the tax code, which governs deferred compensation and imposes penalties when options are granted with a strike price below the fair market value of the underlying stock. The valuation is the company's defense against that penalty. For employees it has practical consequences well beyond the grant date.

What the valuation is and who produces it

A 409A valuation is an appraisal of the fair market value of a private company's common stock. As Carta's guide explains, its main purpose is to determine the minimum strike price for new option grants, and it is valid for at most 12 months, or less if a material event such as a financing round or an acquisition offer occurs first.

The tax regulations create a presumption that a valuation is reasonable if it meets certain requirements. Under the Section 409A regulations, an independent appraisal dated within 12 months of the grant qualifies, as does a written valuation of an illiquid start-up prepared by someone with significant experience, generally at least five years in valuation or a related field. That presumption is why nearly every venture-backed company hires an outside firm to produce the number rather than estimating it internally.

Why it is lower than the preferred price

Employees often notice that their strike price is a fraction of what investors paid in the most recent round. That is expected. Investors buy preferred stock with liquidation preferences, anti-dilution rights, and other protections that common stock lacks, so common shares are legitimately worth less. Appraisers then apply a discount for lack of marketability, which Carta notes typically runs 25% to 35%, to reflect the absence of a market for the shares. The result is that the 409A value is almost always below the fundraising valuation. A low strike price relative to preferred price is good for option holders, since it means more potential spread, but it should not be read as a signal about what a buyer would pay.

Why employees should track it

The 409A value matters most at exercise. For nonstatutory options, the spread between the 409A value and the strike price at exercise is ordinary income under IRS Topic 427. For incentive stock options, that same spread is an alternative minimum tax preference item on Form 6251, which can generate a cash tax bill on shares that cannot be sold. Because the 2026 AMT exemption of $140,200 for joint filers phases out above $1,000,000 of income, per the IRS inflation adjustments, the size of the 409A-based spread can determine whether an exercise is affordable.

Consider a hypothetical: an employee holds 10,000 ISOs at a $1 strike. If the 409A value is $4, exercising creates a $30,000 preference item. If the employee waits and a new round lifts the 409A value to $15, the same exercise creates a $140,000 preference item. Nothing about the employee's economic position changed, but the tax cost of exercising did. This is why some option holders pay attention to the timing of financing rounds and the resulting valuation refreshes.

What it does not tell you

A 409A valuation is a compliance document, not a forecast. It does not tell you what your shares would fetch in a tender offer, which is often priced closer to the preferred price, nor what they would be worth in an acquisition after preferences are paid. Employees who exercise and later see the company sold for less than its preference stack can lose their entire investment even though the paper spread looked large.

The valuation can also decline. Down rounds, weak results, or a broad reset in private market pricing can push the 409A value below the strike price of earlier grants, leaving those options underwater. Some companies reprice options in that situation, but they are not required to.

Questions worth asking

Employees can reasonably ask for the current 409A value, the date of the last valuation, and whether a financing is expected that would trigger a refresh. Those three facts, combined with your strike price and share count, are what a tax professional needs to estimate the cost of an exercise.

This article is educational only and is not investment, tax, or legal advice. Please consult a qualified professional before exercising options or making decisions based on a valuation.

Important Disclosures

Important Disclosures: Propulsion Capital Management is an investment adviser registered with the State of California Department of Financial Protection and Innovation. Registration does not imply a certain level of skill or training. This article is provided for general informational and educational purposes only and does not constitute investment, tax, legal, or accounting advice, nor an offer or solicitation to buy or sell any security or to adopt any particular investment strategy. The information is believed to be accurate as of the date of publication but is subject to change without notice; tax laws and regulations change frequently and their application depends on individual facts and circumstances. Nothing herein should be relied upon as a substitute for personalized advice from a qualified professional. Investing involves risk, including the possible loss of principal, and past performance is no guarantee of future results. Diversification does not ensure a profit or protect against loss. Any examples are hypothetical, are for illustrative purposes only, and do not reflect the experience of any client. Links to third-party websites are provided for convenience; Propulsion Capital Management does not endorse, and is not responsible for, the content of third-party sites. Propulsion Capital Management does not provide tax or legal advice; please consult your tax adviser or attorney regarding your specific situation.