When a private company grants stock options or RSUs to employees, it isn’t a matter of adapting a standard appraisal to fit an HR decision. It’s entering a distinct valuation engagement that is governed by its own regulatory frameworks, methodology, and timing constraints.
Two frameworks define the obligation. Section 409A (IRS) sets the pricing requirement for options, while ASC 718 (FASB) governs how equity awards are recognized as a compensation expense. Both apply independently of any transaction context, and neither can be satisfied by repurposing an M&A, estate, or litigation appraisal.
The tax consequences of getting it wrong fall on employees first. Options priced below FMV trigger an additional 20% federal income tax on the employee. For CFOs and legal counsel managing an equity compensation program, understanding what makes this engagement distinct and defensible is where the process begins.
Section 409A and ASC 718: The Governing Frameworks
The two frameworks operate in parallel but address separate obligations.
Section 409A creates the pricing requirement. Under 26 U.S.C. § 409A, options granted below FMV trigger immediate income inclusion and an additional 20% federal income tax on the employee. The statute provides a workaround: a qualified independent appraisal creates a safe harbor, establishing a presumption that the option was priced correctly and shifting the burden of proof to the IRS.
ASC 718 creates the accounting requirement. Any company with GAAP reporting obligations, including private companies preparing for an audit, pursuing institutional financing, or preparing for a public offering, must recognize the fair value of options, RSUs, ESPPs, and other equity instruments as compensation expenses.
Under FASB ASU 2021-07, qualifying private companies may elect a practical expedient that permits the use of a reasonable application of the Section 409A valuation framework in determining the current price of the underlying share for certain equity-classified awards. Additional ASC 718 analyses may still be required.
RSUs require separate consideration. At private companies, they’re typically structured to fall outside the scope of 409A through the short-term deferral exception, but they still require a defensible FMV under ASC 718. Legal counsel should confirm whether the engagement is scoped to cover the right instruments before work begins. Those requirements also explain why a general-purpose appraisal can’t simply be repurposed for this context.
How This Differs from Other Appraisals
A business valuation for a transaction answers the question of what a buyer would pay. A 409A valuation answers what the fair market value of common stock is.
The analysis must account for the full preferred equity stack, including liquidation preferences, participation rights, and anti-dilution provisions, and allocate value specifically to common stock. The Option Pricing Method (OPM), Probability-Weighted Expected Return Method (PWERM), Current Value Method (CVM), and hybrid approaches are commonly used to allocate equity value among securities with different economic rights and can be particularly important in 409A and ASC 718 valuations.
The defensive posture is also different. A 409A or ASC 718 valuation is designed to satisfy IRS scrutiny and auditor review. Meanwhile, a litigation appraisal is built for cross-examination.
In any case, one constraint is fixed regardless of approach: the exercise price must be at least equal to the fair market value on the grant date. As a practical matter, companies generally should complete the valuation before approving grants so the board has contemporaneous support for the exercise price.
The Safe Harbor: What It Covers and When It Expires
Under Treasury Regulation § 1.409A-1(b)(5)(iv)(B), options priced using a qualified independent appraisal are presumed to reflect FMV. Without this presumption, the company bears the burden of affirmatively demonstrating that the option price was at or above FMV at the grant date.
To qualify, the appraisal must be performed by a firm that is genuinely independent and accountable for the accuracy of the report. To obtain the independent-appraisal presumption, the valuation must satisfy the requirements of Treasury Regulation § 1.409A-1(b)(5)(iv)(B). Other presumptions may also be available, including those for certain illiquid startup stock and qualifying formula-based valuations.
The safe harbor extends up to 12 months from the valuation date, but only if no material event occurs in the interim. Events that may cause the prior valuation to become stale and warrant a new appraisal include a new preferred equity financing round, initiation of a sale or IPO process, and any significant change in financial performance or business trajectory.
As WilmerHale’s analysis of the IRS final regulations notes, companies that regularly issue equity need the valuation process built into their grant calendar and should never initiate it only when a grant is imminent. A reactive approach creates gaps that the safe harbor doesn’t cover.
What the Valuation Firm Needs from Your Company
A 409A or ASC 718 engagement moves efficiently when the company arrives prepared. Expect the appraisal firm to request:
- Cap table: All equity classes, conversion rights, liquidation preferences, and outstanding options and warrants.
- Financial statements: Most recent financials plus any board-approved projections or budget.
- Recent financing activity: Term sheets, closing documents, and post-money valuations from any preferred equity rounds.
- Material events: Any development since the last valuation that could affect FMV, such as strategic changes, significant contract wins or losses, or shifts in market conditions.
- Equity plan documents: The stock plan, form option agreements, and board resolutions authorizing prior grants.
WilmerHale’s guidance on stock option pricing for private companies notes that the chosen allocation method can significantly affect the common stock’s value, particularly when a near-term liquidity event is a probable outcome. Companies with multiple preferred rounds, convertible notes, or outstanding warrants should expect a more involved analysis. That complexity also bears on how often the valuation will need to be refreshed.
Frequency: When to Refresh a 409A Valuation
The 12-month window is a maximum, not a default. Companies with active hiring programs or frequent grant cycles should treat annual refreshes as a floor.
Specific events require a new valuation before the window expires, such as closing a new equity round, a material change in financial performance, and initiation of an M&A or IPO process. For companies approaching any of these, the prior appraisal may be stale well before 12 months have passed.
The cost comparison is direct. Employees who receive options priced below FMV face an additional 20% federal income tax, which is a liability that, along with the reputational exposure it creates, routinely exceeds the cost of maintaining a current valuation. As F.W. Cook’s overview of stock compensation accounting notes, audit scrutiny on share-based payments has intensified for companies approaching institutional financing or a public offering, so this must be kept in mind.
A Valuation Built for the Regulatory Context
Stock-based compensation valuations require purpose-specific methodology, regulatory framing, and documentation. The 409A safe harbor protects both the company and its employees, but only if the appraisal is qualified, timely, and refreshed when material events occur.
RSUs and options have different scoping requirements, and the allocation method matters for companies with complex capital structures. For those approaching a liquidity event, the quality of the appraisal affects audit review and investor due diligence.
Appraisal Economics has conducted 409A and ASC 718 valuations across company stages and capital structures for more than three decades. The firm’s team of CFAs, ASAs, and CPAs has worked through the full range of scenarios described in this post. The IRS has retained Appraisal Economics to independently review and critique third-party valuation reports in contested matters.