409A

A 409A is an independent appraisal of a private company's common stock fair market value (FMV), required by Section 409A of the Internal Revenue Code before any compensatory stock options can be granted at that price. If options are granted below FMV — even inadvertently — the employee faces immediate ordinary income tax on the full discount plus a 20% penalty tax.

Because preferred shares carry liquidation preferences, dividend rights, and other protections, they are worth more than common shares. The 409A accounts for this by applying a discount — sometimes called the "preferred vs. common spread" — and arrives at a per-share FMV for common stock. This is the floor for option strike prices.

Illustrative example: a company last raised at a $100M preferred valuation. The 409A appraisal, accounting for the liquidation preference and conversion discount on the preferred, may conclude that common stock FMV is $6.00 per share, while the preferred is effectively priced at $10.00 per share. Options are then struck at $6.00.

The edge the pros know: the gap between the 409A common FMV and the latest preferred round price is a market-moving data point. A large spread (e.g., common at 30% of preferred) implies the appraisor believes liquidation preferences significantly disadvantage common holders. A narrow spread (80–90%) implies near-parity, often seen in pre-IPO companies where preferred will convert to common at listing.