409A valuation explained, and India's ESOP equivalent

Why it exists

If options are granted with an exercise price below the stock's fair market value, US tax rules can treat the difference as deferred compensation, with penalties for employees. An independent 409A appraisal gives the company a defensible "safe harbour" price.

Common stock in a startup is normally valued well below the price investors paid for preferred shares, because preferred shares carry liquidation preferences and other rights. That gap is what lets early employees get options at a low exercise price.

When a startup needs one

• Before granting stock options for the first time.
• At least every 12 months while it keeps granting options.
• After a material event, such as a new funding round, a large change in the business or an acquisition offer.

The Indian equivalent

India has no 409A, but ESOP valuation matters just as much. When an employee exercises options, the difference between the fair market value of the shares and the exercise price is taxed as salary (a perquisite), and the gain on sale is taxed again as capital gains. For unlisted companies, the FMV for this purpose is set by a valuation from a registered merchant banker under the income tax rules.

Eligible DPIIT-recognised startups can let employees defer the tax on exercise until a later event, such as sale or leaving the company. The rules change with budgets, so check our ESOP taxation guide and a tax adviser before relying on a specific treatment.

How the valuation is done

Valuers usually combine several methods. A market approach compares the company with similar public companies or recent deals; an income approach discounts expected future cash flows; and for venture-backed startups, the most common is a "backsolve" from the latest funding round, using an option-pricing model to split the company's value between preferred and common shares. A discount for lack of marketability is then applied, because private shares cannot easily be sold.

In India, registered valuers and merchant bankers use broadly similar methods, typically a discounted cash flow or net asset value approach, and the valuation report is kept on file in case the tax authorities question the figure.

What founders should do

Get the first valuation done before granting any options, refresh it at least yearly and after each funding round, and keep the reports. Grant options only at or above the current fair market value. Explain to employees, in writing, what their options cost to exercise and when tax is due: surprise tax bills on exercise are one of the most common sources of frustration with startup equity, in India and elsewhere.