📌 Educational Resource Disclaimer
This glossary provides general explanations of common equity terms. These definitions and examples are for educational purposes only and do not constitute legal, financial, or tax advice.
Equity structures vary significantly between companies, and your specific situation may have unique terms and conditions. For guidance on how these concepts apply to your individual situation, please consult with a qualified legal, financial, or tax professional.
409A Valuation
An independent appraisal of your company’s common stock fair market value, required by IRS regulations. This determines the strike price for stock options.
Why it’s required:
IRS Section 409A requires stock options to be granted at or above fair market value
Otherwise: Penalties and taxes for option holders
Safe harbor: Get independent 409A valuation
How often:
At company formation
Before any option grants
After material events (funding round, significant business changes)
A 409a is valid for 1 year starting from the Valuation Date
What determines FMV:
Recent funding rounds (preferred stock price)
Company financials and metrics
Market comparables
Discounts for illiquidity
Example:
Company raises Series A at $2.00/share (preferred stock)
409A valuation: Common stock worth $0.50/share (after applying discounts)
Employee stock options: Granted at $0.50 strike price
Why preferred ≠ common:
Preferred has liquidation preferences, downside protection
Common is subordinated, less valuable
Why it matters: 409A valuations determine your strike price. You want it done right to avoid IRS penalties, but a lower valuation means cheaper options for employees.
Black-Scholes Option Pricing Model
A mathematical formula used to estimate the theoretical fair value of stock options by considering multiple variables including stock price, exercise price, time to expiration, volatility, risk-free interest rate, and dividends. Widely used in 409A valuations to determine the fair market value of employee stock options for tax and compliance purposes.
Key inputs:
Current stock price (FMV)
Exercise/strike price
Time to expiration
Volatility (expected price fluctuation)
Risk-free rate (Treasury yield)
Expected dividends (usually zero for startups)
Formula output: The model calculates a theoretical option value that reflects:
Intrinsic value (if any)
Time value (opportunity for future appreciation)
Volatility premium (higher volatility = higher value)
How it's used in 409A valuations:
Determine common stock FMV
Set strike price equal to FMV
Input volatility estimates (from comparable companies)
Use appropriate risk-free rate
Model calculates option value for accounting/tax purposes
Example calculation inputs:
Common stock FMV: $2.00
Strike price: $2.00
Time to expiration: 7 years
Volatility: 45%
Risk-free rate: 4%
Expected dividends: 0%
Black-Scholes value: ~$1.20 per option
Why it matters: The Black-Scholes model is the standard method for valuing options in 409A reports. Understanding the inputs helps you see how option values are calculated and why volatility and time to exit significantly impact option worth.
Fair Market Value (FMV)
The price that a willing buyer would pay and a willing seller would accept for a share, neither being under any compulsion to transact. For private companies, determined by 409A valuation.
Used for:
Setting stock option strike prices
Calculating taxes on equity events
Determining spread for option exercises
Valuing equity grants for accounting
Why it matters: FMV drives all equity pricing and tax calculations. It’s especially important for options and early exercise decisions.
Preferred Stock Price
The price per share that investors pay for preferred stock in a priced funding round. This is typically much higher than the common stock FMV.
Example:
Series A: Investors pay $2.00/share for preferred stock
Same time: Common stock FMV (per 409A) is $0.50/share
Difference: Preferred stock has liquidation preference and other protections
Why it matters: Don’t confuse preferred price with common stock value. Employees’ options are priced at common FMV, which is substantially lower than preferred.
Probability Weighted Time to Exit
A valuation methodology that assigns probabilities to different potential exit scenarios (IPO, acquisition, dissolution) and their respective timeframes, then calculates a weighted average to determine the expected time to liquidity. This approach provides a more nuanced valuation than a single time-to-exit assumption by accounting for multiple possible outcomes and their likelihoods.
Key characteristics:
Multiple exit scenarios modeled
Each scenario assigned probability
Each scenario has different timing
Weighted average calculated
More sophisticated than single estimate
Common scenarios modeled:
IPO: Typically longer timeline (5-7 years), higher value
Strategic acquisition: Medium timeline (3-5 years), moderate value
Financial acquisition: Medium timeline (3-4 years), lower value
Dissolution/failure: Shorter timeline (1-2 years), minimal/zero value
How it works:
Example calculation:
Scenario 1 - IPO: 30% probability, 6 years
Scenario 2 - Strategic acquisition: 50% probability, 4 years
Scenario 3 - Financial acquisition: 15% probability, 3 years
Scenario 4 - Dissolution: 5% probability, 1 year
Probability-weighted time to exit: (0.30 × 6) + (0.50 × 4) + (0.15 × 3) + (0.05 × 1) = 4.3 years
Impact on valuation:
Example with values:
Scenario | Probability | Time | Exit Value | Weighted Value |
IPO | 25% | 6 yrs | $500M | $125M |
Acquisition | 60% | 4 yrs | $200M | $120M |
Fire sale | 10% | 2 yrs | $50M | $5M |
Dissolution | 5% | 1 yr | $0 | $0 |
Total probability-weighted value: $250M
Probability-weighted time: 4.35 years
When it's used:
More mature 409A valuations
Complex cap table scenarios
Companies with multiple strategic options
Later-stage companies with clearer paths
Why it matters: Probability-weighted time to exit provides a more realistic valuation than assuming a single outcome. It acknowledges that startups face multiple possible futures with different probabilities and timeframes. This methodology often results in lower option values than assuming a single successful exit, reflecting actual risk.
Risk-Free Rate
The theoretical rate of return on an investment with zero risk, typically represented by U.S. Treasury securities (such as Treasury bills or bonds) with a maturity matching the time horizon of the investment being valued. In the Black-Scholes model and 409A valuations, the risk-free rate serves as a baseline for discounting future cash flows and determining option values.
Key characteristics:
Based on U.S. Treasury yields
Matches time horizon of investment
Reflects time value of money
Changes with market conditions
Currently ~4-5% (varies with Fed policy)
Which Treasury to use:
Short-term options (<1 year): Treasury bills
Medium-term (1-5 years): Treasury notes
Long-term (5-10 years): Treasury bonds
Typical for startups: 5-year Treasury note (most common time to exit)
How it's used in option pricing:
The risk-free rate affects option values by:
Higher rates = higher option values (time value of waiting is greater)
Lower rates = lower option values (less opportunity cost of waiting)
Example: Same option with different risk-free rates:
Strike price: $1.00
Stock price: $1.00
Volatility: 45%
Time to exit: 5 years
Risk-Free Rate | Option Value |
2% | $0.72 |
4% | $0.78 |
6% | $0.84 |
Current environment (2024-2026):
Fed rates elevated to combat inflation
5-year Treasury: ~4-4.5%
Higher than 2010-2021 period (near zero)
Increases option values vs. low-rate environment
Why it matters: The risk-free rate is a fundamental input in option pricing that reflects macroeconomic conditions. When Fed rates change, it affects option valuations in 409A reports. Understanding the risk-free rate helps you see how broader economic factors influence your equity compensation value.
Time to Exit
The estimated period until a liquidity event (such as an IPO or acquisition) occurs. In 409A valuations, time to exit is a critical assumption used to determine option values, as it affects both the expected holding period and the probability-weighted scenarios for company valuation at exit.
Key characteristics:
Expressed in years (e.g., 5 years)
Based on company stage and market conditions
Affects option value in pricing models
Longer time = more opportunity for appreciation
Can be single estimate or probability-weighted
How it's estimated: Valuation firms consider:
Company development stage
Historical time to exit for comparables
Current market conditions
Management projections
Funding runway and needs
Impact on option value:
Example: Same option with different time to exit:
Strike price: $1.00
Stock price: $1.00
Volatility: 45%
Risk-free rate: 4%
Time to Exit | Option Value |
2 years | $0.52 |
5 years | $0.78 |
7 years | $0.91 |
Longer time to exit generally increases option value because there's more time for the stock to appreciate.
Stage-based expectations:
Seed/Series A: 5-7 years to exit
Series B/C: 3-5 years to exit
Late stage: 1-3 years to exit
Why it matters: Time to exit directly impacts option valuations in 409A reports. Companies earlier in their journey will typically have longer time to exit assumptions, which increases option values for accounting purposes but also reflects the longer wait until potential liquidity.
Volatility
A statistical measure of the degree of variation in a company's stock price over time, expressed as an annualized percentage. In the context of 409A valuations and option pricing, volatility represents the expected fluctuation in stock price and is a key input in the Black-Scholes model. Higher volatility increases option value because there's greater potential for significant price movements.
Key characteristics:
Expressed as annual percentage (e.g., 40% volatility)
Measured by standard deviation of returns
Higher volatility = higher option values
Estimated using comparable public companies for startups
Critical input in option pricing models
How it's calculated for startups: Since private companies have no trading history, valuation firms estimate volatility using:
Public company comparables in same industry
Stage-matched peer groups
Adjustment for private company factors
Typical range: 30-60% for early-stage startups
Impact on option value:
Example: Same option with different volatility assumptions:
Strike price: $1.00
Stock price: $1.00
Time to exit: 5 years
Risk-free rate: 4%
Volatility | Option Value |
20% | $0.45 |
40% | $0.68 |
60% | $0.89 |
Higher volatility means greater uncertainty, which increases the chance of big gains (options benefit from upside without downside below strike price).
Why it matters: Volatility is one of the most impactful variables in option pricing. A company with 60% volatility will have options worth significantly more than a company with 30% volatility, even at the same FMV. Understanding volatility helps you appreciate option value beyond just the spread.