Why Can’t I Just Pick a Low Strike Price for My Team’s Stock Options?

You’re preparing to hire your first employees. To make the offer more attractive, you plan to grant stock options with a very low strike price.

After all, the lower the strike price, the more valuable the options appear.

Then someone tells you that you first need a 409A valuation.

At first, it seems like an unnecessary expense.

In reality, a 409A valuation protects both your company and your employees. Setting option prices below fair market value can create significant tax consequences, including additional taxes and penalties for the very people you are trying to reward.

What Is a 409A Valuation?

A 409A valuation is an independent appraisal of the fair market value (FMV) of your company’s common stock.

Under Section 409A of the Internal Revenue Code, stock options generally should be granted with a strike price at or above that fair market value.

The valuation provides objective support for the strike price used in your equity grants.

Without it, the company may have difficulty demonstrating that the options were priced correctly.

Common Stock Is Usually Worth Less Than Preferred Stock

Many founders assume their common stock should be worth the same price investors recently paid in a financing round. That is rarely the case.

Preferred stock often includes valuable rights such as:

• Liquidation preferences.
• Protective provisions.
• Other investor protections.

Because common stock does not include these rights, its fair market value is often lower than the preferred share price paid by venture investors.

A properly prepared 409A valuation accounts for these differences.

A Qualified Valuation Provides Safe Harbor

One of the biggest advantages of obtaining an independent 409A valuation is the safe harbor it provides.

When the valuation is prepared by a qualified independent provider, the IRS generally presumes the fair market value is reasonable unless it can prove otherwise.

Without that protection, the burden shifts to the company to defend the strike price if it is challenged.

This creates additional uncertainty for both founders and employees.

A 409A Valuation Must Be Updated

A 409A valuation is not permanent. Companies should generally obtain a new valuation:

• At least every 12 months.
• After a new financing round.
• Following other significant corporate events, such as acquisition discussions or major changes in the business.

Continuing to issue options using an outdated valuation may expose the company and option holders to unnecessary tax risks.

An Artificially Low Strike Price Can Hurt Employees

A low strike price may seem like a generous benefit. 

However, intentionally setting the strike price below fair market value can create serious tax consequences. Employees may face:

• Immediate income tax at vesting.
• An additional 20% federal penalty.
• Interest charges on top of that.

Rather than increasing the value of employee equity, an improperly priced option grant can leave employees with an unexpected tax burden.

Build Your Equity Program on Current Valuations

As your startup grows, equity grants become an important part of attracting and retaining talent.

Founders should establish a process to ensure:

• Every option grant is based on a current 409A valuation.
• Strike prices are set at or above the appraised fair market value.
• Valuations are refreshed after material events.
• Grant documents reference the applicable valuation date.

Maintaining these practices helps protect both the company and its employees as additional option grants are made.

Common Founder Mistakes

• Granting options before obtaining a 409A valuation: Guessing the fair market value eliminates the benefit of safe harbor protection and may expose employees to unnecessary tax consequences.
• Trying to achieve the lowest possible strike price: An artificially low valuation may seem attractive, but it can create immediate tax liability, additional penalties, and interest if challenged.
• Continuing to use an outdated valuation after a financing round: Significant corporate events often require a refreshed 409A valuation before issuing additional stock options.
• Assuming preferred stock and common stock should have the same value: Preferred shares typically include rights that make them more valuable than common stock, so the two prices are rarely identical.

10-Minute 409A Valuation Self Check

• Do I have a current 409A valuation before granting stock options?
• Was the valuation prepared by a qualified independent provider?
• Are all strike prices at or above the appraised fair market value?
• Is my valuation less than 12 months old?
• Have I updated the valuation after my most recent financing?
• Do my equity grant documents reference the applicable valuation date?

If you cannot answer yes to all of these, you are not ready to grant options yet.

Bottom Line

A 409A valuation is much more than a compliance requirement. It establishes a defensible fair market value for your common stock, supports employee stock option pricing, and provides valuable tax protection for both the company and its option holders. Keeping valuations current and using them consistently helps startups build an equity program that rewards employees without creating unnecessary tax risk.

Want to Hand Out Equity Without a Hidden Tax Trap?

Join our upcoming Product Launch Master Class to learn the legal mistakes that frequently delay product launches, the key documents founders often overlook, and the practical steps to prepare your startup before going to market.

Reserve your seat: https://primumlaw.com/product-launch-master-class/