Private companies issuing stock options obtain an independent valuation before setting the exercise price. The purpose is defensive, and misunderstanding it creates avoidable exposure.
Options must be priced at fair market value
Tax rules require that options on private company stock carry an exercise price no lower than the fair market value of the shares on the grant date.
Because there is no public market, that value has to be determined by analysis rather than observed, which is what the independent valuation provides.
Granting below fair market value can create significant adverse consequences for the recipient rather than the company, which is why employees have a direct interest in the process.
A qualified appraisal shifts the burden of proof
Valuations performed by an independent appraiser under the applicable rules are presumed reasonable, and challenging them requires showing the valuation was grossly unreasonable.
Without one, the company must demonstrate that its chosen price was reasonable, using whatever evidence it assembled at the time.
That difference in burden is the practical reason companies pay for the exercise rather than estimating internally.
Common stock is valued below preferred
Investors buy preferred shares carrying liquidation preferences, dividend rights, protective provisions and other terms. Employees receive common stock without them.
The valuation quantifies that difference, which is why the option price is normally well below the price investors recently paid for preferred stock.
The gap narrows as a company matures and the probability of outcomes where preferences matter declines.
The valuation has a limited life
A valuation is generally relied on for a defined period, and material events require a new one before further grants are issued.
Financing rounds, acquisitions, significant changes in performance and preparation for a public listing all qualify as material events.
Companies granting options continuously therefore refresh the valuation on a schedule, and grants made against a stale figure carry the risk the exercise was meant to remove.
Method depends on stage and evidence
Appraisers apply market, income and asset approaches, weighting them according to what evidence exists. Early companies with no revenue rely more heavily on recent transaction prices.
Allocation between share classes uses recognized models that account for liquidation preferences and the probability of different exit scenarios.
Because the rules are technical, carry consequences for individual recipients, and change over time, equity compensation should be structured with a qualified appraiser, corporate counsel and a tax adviser rather than from a template.