Every private company that grants stock options needs a 409A valuation, an independent estimate of what the stock is worth. That number sets the exercise price on your options. As long as the exercise price matches or exceeds the 409A value, everything is straightforward from a tax perspective.
The system works well when a company's value is genuinely hard to pin down. It works less well when people are buying and selling the stock on secondary markets at two or three times the 409A number.
That gap is what creates the exposure. Late-stage companies, particularly in AI, have seen secondary prices pull far ahead of their most recent 409A values. Employees exercise options at the lower 409A price, report a modest gain, and in an audit the IRS may point to secondary sales or tender offers suggesting the stock was actually worth more.
That doesn't mean the secondary price is the "real" price. A 409A appraisal accounts for the fact that private shares can't be freely sold and that common stockholders don't control the company. Both of those factors lower the appraised value. Secondary trades reflect what one buyer was willing to pay in one transaction, often with limited volume or unique terms. A secondary sale at $50 per share doesn't automatically mean the 409A price should be $50.
Where it gets tricky is when something big happens after the last valuation. If the company runs a large tender offer or closes a new funding round at a much higher price, that's hard to ignore. A 409A done 10 months ago may not hold up if there's clear evidence the stock is worth more today.
If the IRS decides the 409A price was too low, the penalty falls primarily on the employee. That means a 20% additional tax on the underpriced amount, plus interest that runs back to the vesting date. On a large option exercise, that can materially increase your tax bill on a single exercise. Companies can face issues too, around tax withholding, reporting, and their valuation practices, but the direct financial hit lands on the individual.
In practice, the IRS has rarely audited individual employees over 409A valuations. They typically go after the company first. If the company's valuation methodology is disqualified, the effect hits every employee who exercised during that window.
What's worth doing about it?
Two things. First, check whether your company's 409A has been updated in the last 12 months, and whether anything significant (a tender offer, a new funding round) has happened since. Second, if you're planning a large exercise, understand that an outdated or aggressive 409A valuation is a risk you carry more than anyone else.
For educational purposes only. Not tax, legal, or investment advice.