Private companies value their common stock for two different rulebooks: tax, where IRC §409A regulations require stock options to carry an exercise price no lower than fair market value on the grant date [1], and financial reporting, where ASC 820 defines fair value as an exit price between market participants [3]. Funds apply the IPEV Guidelines to estimate the fair value of their holdings, calibrating to recent rounds without treating them as automatically fair [4]. Both regimes allocate value across share classes, which is why common is usually worth less than the latest preferred price.
In this lesson you will
- Explain why stock option exercise prices must be set at or above fair market value under §409A
- List the regulatory presumptions of reasonableness for private-company stock valuations
- Define fair value and the Level 1–3 input hierarchy under ASC 820
- Allocate equity value to common stock with a simple probability-weighted scenario example
Why 409A valuations exist
Section 409A governs nonqualified deferred compensation, and stock options can fall inside it. Under the Treasury regulations, an option does not provide for a deferral of compensation if its exercise price may never be less than the fair market value of the underlying stock on the grant date, the number of shares is fixed at grant, and the option has no other deferral feature [1]. In other words, an option priced at or above fair market value on the grant date is generally outside §409A; one priced below it can be pulled in.
The consequences of failing are significant. The IRS's audit technique guide explains that deferrals includible in income because of a §409A violation are reported separately on Form W-2 (box 12, code Z) and are also subject to an additional 20% income tax and a premium interest tax [2]. That is why companies obtain a formal valuation before granting options.
What counts as a reasonable valuation
For stock that is not readily tradable, fair market value means a value determined by the reasonable application of a reasonable valuation method, judged on the facts and circumstances as of the valuation date [1]. The factors to consider include the value of tangible and intangible assets, the present value of anticipated future cash flows, the market value of similar companies' stock, recent arm's-length transactions in the stock, and other relevant factors such as control premiums or discounts for lack of marketability [1]. A valuation is not reasonable if it ignores available material information, and a prior value is not reasonable if it fails to reflect later material information or was calculated as of a date more than 12 months earlier [1].
The regulations then list methods that are presumed reasonable, which the IRS can rebut only by showing the method or its application was grossly unreasonable [1].
- Independent appraisal: a valuation by an independent appraisal meeting the statutory requirements, as of a date no more than 12 months before the transaction (for example, the option grant) [1].
- Formula price: a formula used consistently as a nonlapse restriction for transfers of that class of stock, within the conditions the regulation sets [1].
- Illiquid start-up stock: a valuation made reasonably and in good faith and evidenced by a written report, for a company with no material trade or business conducted for 10 years or more and no publicly traded equity [1].
- The start-up method is unavailable if the company reasonably anticipates a change in control within 90 days or a public offering within 180 days [1].
- For the start-up method, the valuer must be qualified; significant experience generally means at least five years of relevant experience in business valuation, financial accounting, investment banking, private equity, secured lending, or similar work [1].
Fair value for financial reporting: ASC 820
U.S. GAAP's Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date [3]. It is a market-based measurement, not an entity-specific one, and the objective is an exit price under current market conditions [3]. When a price for an identical asset is not observable, the entity uses a valuation technique that maximizes relevant observable inputs and minimizes unobservable ones [3].
- Level 1: quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date; a blockage factor based on position size is prohibited [3].
- Level 2: inputs other than Level 1 quoted prices that are observable for the asset or liability, directly or indirectly [3].
- Level 3: unobservable inputs, used to the extent relevant observable inputs are not available [3].
- The hierarchy gives the highest priority to Level 1 inputs and the lowest to Level 3 [3]. Most venture holdings are Level 3.
How funds apply it: the IPEV Guidelines
The IPEV Guidelines translate fair value into practice for private capital. For actively traded investments, available market prices are the exclusive basis for fair value [4]. Otherwise, the valuer uses market, income, or replacement cost approaches, and the price of a recent investment, if it resulted from an orderly transaction, generally represents fair value as of the transaction date and may be a starting point later [4]. The guidelines note that calibration is required by accounting standards, but the price of a recent investment is not automatically fair value [4]. They also caution against applying the value of a financing round to other share classes without considering differences in rights and preferences [4].
To allocate equity value among share classes, IPEV lists scenario-based methods (including the probability-weighted expected return method, or PWERM), the option pricing method (OPM), a hybrid of the two, and the current value method for when an exit is imminent [4]. It observes that practice in some jurisdictions places more weight on hybrid or OPM approaches early in an investment's life [4].
- Worked PWERM for common stock (illustrative). Three exit scenarios in three years, with common value per share after preferences: IPO 30% probability, $10.00; sale 50%, $4.00; dissolution 20%, $0.
- Probability-weighted future value = 0.30 × $10.00 + 0.50 × $4.00 + 0.20 × $0 = $3.00 + $2.00 + $0 = $5.00.
- Discount at 25% for three years: 1.25^3 = 1.953125, so present value = $5.00 ÷ 1.953125 = $2.56.
- Apply a 20% discount for lack of marketability (a factor the 409A regulations list): $2.56 × (1 − 0.20) = $2.048, or about $2.05 per share.
- Compare with a recent Series A price of $3.11: common at about $2.05 is roughly 66% of the preferred price — the gap reflects the preferences and the illiquidity of common.
Key terms
- Section 409A
- The Internal Revenue Code section governing nonqualified deferred compensation; options priced below grant-date fair market value can fall under it.
- 409A valuation
- A valuation of a private company's common stock used to set option exercise prices at or above fair market value.
- Presumption of reasonableness
- Regulatory safe-harbor methods whose results the IRS can rebut only by showing gross unreasonableness.
- Fair value (ASC 820)
- The price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
- Exit price
- The price at which an asset would be sold, as opposed to the price paid to acquire it.
- Level 3 input
- An unobservable input to a fair value measurement, such as a forecast or an unobservable discount rate.
- PWERM
- Probability-weighted expected return method: values share classes by weighting outcomes across discrete exit scenarios.
- Option pricing method (OPM)
- Allocates current equity value across share classes by treating each as a call option on the company's value.
- Discount for lack of marketability (DLOM)
- A reduction reflecting that a security cannot be readily sold.
Check your understanding
Sources
- [1]Electronic Code of Federal Regulations (eCFR), “26 CFR § 1.409A-1 - Definitions and covered plans,” Accessed November 2026.
- [2]Internal Revenue Service, “Nonqualified Deferred Compensation Audit Technique Guide (Publication 5528),” March 20, 2024.
- [3]Financial Accounting Standards Board, “Accounting Standards Update No. 2011-04, Fair Value Measurement (Topic 820),” May 2011.
- [4]IPEV Board, “International Private Equity and Venture Capital Valuation Guidelines,” December 2025.
Educational content only — not legal, tax, or investment advice, or an offer to sell or a solicitation of an offer to buy any security. Rules and data are described as of November 2026 and may change. Securities offered through Umergence LLC, Member FINRA/SIPC.