Meaning
An estimate of the price an asset would sell for on the open market provides the basis for tax assessments and stock option pricing. Determining the fair market value of private company shares requires a 409A appraisal from an independent firm. This value is used to set the strike price for options so that they are not considered deferred compensation.
Valuation Basis
External auditors look at the company’s financials, market comparables and recent fundraising history to reach a number. The fair market value often differs from the post-money valuation set by venture capitalists because it accounts for the lack of liquidity. It is a conservative estimate of what a common share is worth today.
Pricing Risk
Setting the strike price too low can lead to heavy tax penalties for the employees and the company. If the fair market value is underestimated, the government may view the options as an immediate gift of value. This risk requires the board to update the appraisal at least once every twelve months.
Appraisal Requirement
Compliance with federal laws makes the annual valuation a mandatory and expensive part of running a startup. The founder must spend time gathering data and explaining the business model to the appraisers to ensure the result is accurate. The cost of these reports is a permanent line item in the company’s budget.
Keeping an updated record of this value is the only way to issue equity safely to new team members.