To determine the fair market value of a startup’s common stock, hire a qualified independent appraiser to run a Section 409A valuation: they estimate the total value of the company, allocate that value across preferred and common share classes, apply discounts for illiquidity and lack of control, and produce a per-share number you can defend to the IRS. That number is what you use as the exercise price when you grant stock options, and it stays valid for twelve months or until a material event forces a fresh look.
The rest of this article walks through what “fair market value” actually means for a private company, why 409A is the framework that controls the answer, how appraisers arrive at the number, and when you need to redo the work.
What Fair Market Value Means for a Private Company
Fair market value is the price at which stock would change hands between a willing buyer and a willing seller, with neither pressured to transact and both having reasonable knowledge of the relevant facts. The standard comes from federal case law and applies across tax valuations. Simple enough on paper. The problem is that a private startup has no ticker, no trading volume, and no public market setting a price, so the entire 409A process exists to construct one.
The point that trips founders up: the value of the whole company is not the value of a single share of common stock. Venture investors buy preferred stock, which sits ahead of common in the payout order. Preferred shares typically carry a liquidation preference guaranteeing the investor gets their money back, or a multiple of it, before common shareholders see a dollar. Under a non-participating structure, investors choose between taking the preference or converting to common at their ownership percentage, whichever pays more. Under a participating structure, they collect the preference and then share in what’s left alongside common holders.
Because of that structural priority, common stock is worth substantially less per share than preferred. In a modest exit, heavy liquidation preferences can leave founders and employees with very little. Any credible valuation captures that gap, which is why the per-share FMV of common stock granted to employees typically lands well below the price investors paid for preferred.
Why Section 409A Controls the Answer
Section 409A of the Internal Revenue Code governs nonqualified deferred compensation, and its rule for stock options is direct: the exercise price of a nonqualified stock option must be set at or above the fair market value of the underlying stock on the date of grant.1Office of the Law Revision Counsel. 26 U.S. Code 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans Price an option below FMV and the IRS treats it as granted “in the money,” which triggers tax consequences before the holder has exercised or received a dollar.
Incentive stock options are technically exempt from 409A, but Section 422 imposes its own rule requiring the exercise price to be at least FMV. So whether the grant is an ISO or an NSO, a defensible FMV number is required, and the 409A valuation is the standard way companies produce one.
The penalties for getting it wrong fall on the option holder, not the company. If options are later found to have been priced below FMV, the recipient faces immediate income inclusion on the deferred compensation when it vests, a 20% penalty tax on top of regular income tax, and interest at the underpayment rate plus one percentage point, calculated back to the year the compensation was first deferred or the first year it was no longer subject to a substantial risk of forfeiture.1Office of the Law Revision Counsel. 26 U.S. Code 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans An unexercised option can produce a real tax bill for an employee who had no say in the pricing.
The Three Safe Harbor Methods
Treasury regulations offer three valuation methods that create a presumption of reasonableness. Use one of them and the IRS can only challenge the FMV if the method or its application was “grossly unreasonable,” a high bar. Skip them and the IRS gets to challenge under a plain reasonableness standard.2eCFR. 26 CFR 1.409A-1 – Definitions and Covered Plans
The independent appraisal method uses a qualified independent appraiser, with the valuation dated no more than 12 months before the option grant. This is what most startups use after their first institutional round, and it produces the clearest documentation trail.
The binding formula method uses a formula that constitutes a nonlapse restriction on the stock, applied consistently for all transfers of that stock class to the issuer or its major shareholders.
The illiquid startup presumption is available to companies less than 10 years old that do not expect a change in control or public offering within the next 12 months. The valuation still has to be performed by someone with significant knowledge and experience in similar valuations.
A board-level determination without an outside appraiser does not qualify for any safe harbor. Very early companies sometimes rely on the illiquid startup presumption performed by a knowledgeable insider, but the independent appraisal is the standard once real money has come in.
How an Appraiser Gets to a Per-Share Number
The appraisal moves in three steps: estimate the value of the whole company, allocate that value across the different share classes, and apply discounts that reflect the realities of holding private stock.
Step One: Estimate Enterprise Value
Three standard approaches exist and most 409A reports blend at least two.
The income approach projects the company’s future cash flows and discounts them back using a rate that reflects the company’s risk profile. A high-growth startup with no revenue and heavy burn carries a steep discount rate, which pulls present value down sharply. For pre-revenue companies without reliable forecasts, the income approach tends to play a supporting role.
The market approach compares the company to similar businesses, applying trading multiples from a set of public comparables or recent private transactions to the startup’s own financials. The challenge is finding companies that are genuinely comparable. A pre-revenue biotech and a SaaS company with recurring revenue don’t sit in the same valuation universe even if both are “tech startups.”
The asset approach sums the net value of tangible assets. For most technology startups it produces an artificially low number because the real value sits in intellectual property, customer relationships, and human capital, so appraisers rarely rely on it for software or biotech. It matters more for companies with significant physical infrastructure or inventory.
A backsolve is also common right after a priced round. The appraiser works backward from the price investors just paid to solve for the total equity value implied by that transaction, which anchors the analysis to an actual arm’s-length negotiation.
Step Two: Allocate Value Across Share Classes
This is where common stock drops below the preferred price, because preferred gets paid first and carries rights that common does not.
The option pricing model treats each class of equity as a call option on the company’s total value. The preferred stock’s liquidation preference acts as the exercise price, and the model uses inputs like expected time to a liquidity event and the volatility of comparable public companies to calculate what each class is worth. The OPM suits early-stage companies where the timing and shape of an exit are genuinely unknown, because it models a probability distribution across outcomes rather than forcing a prediction.
The probability-weighted expected return method, or PWERM, defines specific exit scenarios (an IPO at a given valuation, a strategic acquisition, continued private operation, dissolution), assigns each a probability, works out how proceeds would be distributed to each share class under each scenario, and produces a weighted average per-share value for common. It works better for later-stage companies with a clearer path to a specific exit. For a pre-seed company, assigning probabilities to an IPO three years out is mostly speculation.
Step Three: Apply Discounts
Two discounts typically come off the per-share common value produced by the allocation.
The Discount for Lack of Marketability reflects that private company stock cannot be sold on a public exchange. Public shares can be sold tomorrow; startup shares may wait years for a liquidity event, and there’s no guarantee one arrives. That illiquidity reduces what a willing buyer would pay. The size of the discount depends on expected time to liquidity, the presence of any secondary market, and the company’s stage, and the appraiser must justify the specific percentage they pick.
The Discount for Lack of Control reflects that common shareholders typically cannot influence major corporate decisions like a sale, merger, or new financing. Preferred shareholders often hold board seats and protective provisions that give them effective veto power. That power gap reduces the value of a minority common position.
Together, these discounts explain why a startup can raise a Series A at a $50 million post-money valuation while the 409A report sets common stock at a fraction of the preferred price. The old rule of thumb that common should be roughly 10–20% of the preferred price is unreliable; the actual ratio depends on the company’s specific capital structure, liquidation preferences, and proximity to a liquidity event.
What the Appraiser Will Ask For
The valuation moves faster and produces a more defensible number when the company assembles the right documents up front:
- Current and historical income statements, balance sheets, and cash flow statements.
- A complete capitalization table covering all equity classes, option pools, warrants, and convertible instruments.
- Term sheets and stock purchase agreements from recent financing rounds.
- A 12-to-24-month financial forecast with supporting assumptions.
- Pitch deck, major contracts, intellectual property portfolio, and notes on any significant recent events.
Expect pushback on projections that assume hockey-stick growth without evidence or ignore known competitive threats. Defensible projections with clear assumptions produce more reliable valuations and reduce the risk of an IRS challenge.
Cost depends on complexity. Early-stage startups with simple cap tables run roughly $2,000 to $5,000, with prices climbing for later-stage companies that have multiple preferred series, complex waterfalls, or convertible instruments. The engagement typically takes two to four weeks from kickoff to final report, longer if the company is slow to send documents or the appraiser finds issues that need more analysis.
When the Number Expires
A 409A valuation is valid for 12 months from the date as of which fair market value was measured, not the date the report was delivered. After that, any option grant that relies on the expired valuation falls outside the safe harbor. Calendar the expiration and start the renewal before it hits.2eCFR. 26 CFR 1.409A-1 – Definitions and Covered Plans
The 12-month clock gets overridden by any material event that changes the company’s economic value. The most common trigger is closing a new priced round, because the negotiated price per share is a new data point the old valuation didn’t reflect. Other triggers include completing a significant acquisition, reaching a major product or revenue milestone, losing a key customer, settling material litigation, or receiving a patent. When one of these hits, get a new valuation before granting any additional options.2eCFR. 26 CFR 1.409A-1 – Definitions and Covered Plans
Convertible note financing can trigger an update too. A note with a valuation cap implies a specific company valuation, and that cap may be material information the old report didn’t reflect. Safest practice: treat any financing event as a trigger and confirm with the appraiser before the next grant.
If the Price Was Set Too Low
Mistakes happen. A company may discover after the fact that options were granted below FMV because of a calculation error, a delayed valuation, or a material event the board didn’t recognize at the time. IRS Notice 2008-113 provides a narrow correction window.
If the error is caught in the same tax year as the grant, the company can reset the exercise price to at least the FMV on the original grant date, and the option is treated as if it never violated Section 409A.3Internal Revenue Service. IRS Notice 2008-113 – Guidance on Correcting Certain Failures of Nonqualified Deferred Compensation Plans A second window extends through the end of the tax year immediately following the year of grant, though the option holder must include a small amount of income tied to the discount. Outside those windows, the correction options narrow sharply and the full 409A penalties can apply.
The longer a pricing error sits, the harder and more expensive it is to fix. If you suspect an issue, talk to a tax advisor immediately rather than waiting to see whether the IRS notices.