409A Valuation After a Down Round: What Founders Need to Know
Author: Redwood Valuation Content Team
Published: February 4, 2026
A down round triggers an immediate need for a new 409A valuation. The IRS considers a lower funding round a material event, and your previous valuation no longer reflects fair market value (FMV). For founders, getting this right protects your employees from tax penalties and gives you strategic options for preserving team morale.
Maybe your company just raised money at a lower valuation than your last round—that's hard enough without worrying about compliance requirements. This situation is stressful, but there's good news: the path forward is straightforward if you act promptly.
This article covers three critical areas:
Compliance requirements: What the IRS requires and when you need to act
Valuation mechanics: How a down round affects your 409A and why preferred stock prices differ from common stock valuations
Employee impact and strategy: What underwater options mean for your team and the strategic options available to you
What the IRS Requires After a Down Round
Under IRC Section 409A, a down round qualifies as a material event that may trigger the need for a valuation update. Best practice is to complete a valuation update shortly upon closing the round.
What exactly makes something a "material event"? Events that could significantly affect company valuation qualify. A down round explicitly meets this threshold because the market has priced your company lower.
Material events include:
Closing a new funding round (including down rounds)
Significant changes in financial performance
Major strategic shifts or pivots
Key personnel departures
Material changes to business operations
Safe harbor protection shifts the burden of proof to the IRS, meaning they must demonstrate your valuation is "grossly unreasonable" rather than you proving it's reasonable. Without safe harbor, you'd need to defend your valuation methodology from scratch—a much harder position.
The stakes for employees are real. If stock options are granted at a strike price below fair market value, affected employees face immediate taxation of the difference, plus a 20% penalty tax, plus interest. That's a significant hit for people who expected tax benefits from equity compensation.
How the 409A Valuation Works After a Down Round
When your company closes a down round, the 409A valuation of common stock will likely decrease. The new funding round signals that the market values your company lower, and your appraiser must reflect current market conditions in the fair market value assessment. But the decline isn't automatic or proportional to the preferred stock price drop.
Here's the thing: Preferred stock and common stock are fundamentally different securities.
Preferred stock prices reflect investor expectations—they're not a fair market valuation of common stock. Investors receive liquidation preferences, anti-dilution protections, and other rights that common shareholders lack. This is why venture funding prices shouldn't be used as a proxy for 409A valuations.
In our practice, we see the gap between preferred and common values vary significantly based on the company stage. Early-stage companies might see common stock valued at 20-50% of the preferred price. Later-stage companies might see 50-80%. The specific ratio depends on your capital structure, liquidation stack, and company trajectory.
For 409A valuations, the appraiser considers company-specific factors and circumstances rather than purely hypothetical market participant assumptions. Appraisers must consider the Income, Market, and/or Asset approaches when appropriate, and one or two may be relied upon depending on your company's circumstances.
The real challenge begins when your 409A drops below what employees paid (or would pay) for their options.
The Underwater Options Problem
When your new 409A valuation drops below the strike price of existing options, those options become "underwater." Employees would pay more to exercise than the stock is currently worth. The result: stock options stop motivating your team and may start driving people away.
Signs that underwater options are affecting your team include:
• Key employees updating LinkedIn profiles or taking recruiter calls
• Increased questions about equity compensation during all-hands meetings
• Reduced engagement from senior team members approaching vesting cliffs
• Direct conversations about equity value and future expectations
Consider a senior engineer who joined two years ago at a $20 strike price. If your 409A just dropped to $12, their unvested options—the ones supposed to incentivize another two years of work—represent a guaranteed loss if exercised. The retention tool you built just became a reason to look elsewhere.
And not all employees are affected equally. Someone who joined last month at a $14 strike price has options that still make sense. Someone who joined during your peak valuation? Different story entirely.
The frustration is understandable. We've seen founders struggle with this situation—they know their company's long-term potential, but they can't promise employees the stock will recover. That tension is real.
The good news: founders have options. Several strategic approaches can address underwater equity and preserve team morale.
Strategic Options for Founders
Founders have four main approaches to address underwater options after a down round: keeping strike prices "flat" on new grants, repricing existing options, converting to restricted stock units (RSU), or implementing option buybacks. Each has different costs, complexity, and implications for your team and cap table.
Flat Strike Pricing
Companies can issue new options at the prior 409A strike price (a "flat" strike) rather than the new lower value, preserving perceived value for new grants while staying compliant. This is legal as long as the strike price is at or above the new 409A fair market value.
This approach works well for ongoing hiring and retention grants. New employees see strike prices that feel reasonable compared to your company's potential. But it doesn't solve the problem for employees whose existing options are already underwater.
Option Repricing
Repricing lowers the strike price on existing options to match (or approach) the current 409A valuation. This directly addresses underwater options by making them valuable again.
Repricing isn't free, though. The total costs can be significant when you add everything up, and they vary based on company size, option pool complexity, and accounting treatment.
For many companies, however, the retention value exceeds the cost. Losing key engineers or executives is far more expensive than repricing.
RSU Conversion
Converting options to RSUs removes the strike price problem entirely. Employees receive shares at vesting without paying anything—they're just taxed on the value received.
RSU conversion is more common at later-stage companies with established valuations. Early-stage companies often prefer options for tax efficiency and cash conservation. The decision depends on your company's stage, cash position, and employee expectations.
Option Buyback
Some companies repurchase underwater options at a discount, giving employees cash instead of illiquid equity. This uses company cash but can be an effective reset for morale.
No single approach is "best." The right choice depends on your company stage, cash position, employee demographics, and cap table considerations. Regardless of which strategic approach fits your situation, you'll need a current 409A valuation to execute any of them.
Getting the 409A Valuation Updated
A 409A valuation update typically takes 3-4 weeks from engagement to final report, assuming your financial information is organized. This timeline can be expedited if necessary, and most companies find the process straightforward once they pull together the key documents. Costs generally range from $4,000 to $10,000+, depending on company size and complexity.
What you'll need to provide your appraiser:
Current cap table showing all share classes and option pools
Recent financial statements (at least trailing 12 months) as well as 3+ years of historical financials
Board-approved financial projections
Down round term sheet and closing documents
Business updates and other key factors that may affect valuation
Any material changes since your last valuation
And a handful of other factors
The appraiser must be a qualified independent professional with five or more years of relevant experience. Under IRC 409A, "independent" means the appraiser has no financial interest in the outcome and wasn't involved in negotiating your funding round.
The resulting written report becomes your audit trail. It documents methodology, supports your strike price decisions, and—critically—maintains your safe harbor protection. If the IRS ever questions your valuation, this report is what you'll point to.
Companies that delay valuation updates create unnecessary risk. The old valuation no longer reflects reality, and any options granted during that gap may have compliance problems.
The final piece is how to communicate all of this to your team.
Communicating to Your Team
Transparency builds trust. When communicating a down round's impact on equity, acknowledge the reality, explain what the company is doing about it, and express confidence in the path forward. Hiding or minimizing the situation typically backfires, because employees respect and deserve honesty.
Do:
• Be direct about what happened and why
• Explain the impact on existing options honestly
• Share which strategic options you're evaluating (repricing, flat strike, etc.)
• Express confidence in the company's future—but be realistic
• Address proactively before rumors spread
Don't:
• Minimize or hide the situation
• Make promises about future valuations you can't guarantee
• Blame external factors without acknowledging company-specific issues
• Wait until employees ask—they'll interpret silence as avoidance
The conversation is uncomfortable, but employees who understand the situation—and see leadership taking action—are more likely to stay than those who feel misled or ignored.
Key Takeaways
A down round demands prompt action on both compliance and strategy. The key is acting promptly: Update your 409A shortly after closing, evaluate your strategic options for existing equity, and communicate transparently with your team.
Three things to remember:
Compliance: A down round is a material event requiring a 409A update. Best practice is to complete the update shortly after closing; don't wait.
Strategy: You have options—flat strike pricing, repricing, RSU conversion, buybacks. The right approach depends on your situation.
Communication: Transparency builds trust. Address the situation proactively and honestly.
Getting your 409A right after a down round protects employees, preserves your options for addressing underwater equity, and maintains the safe harbor protection that shifts the burden of proof to the IRS.
Questions about your 409A after a down round? Our credentialed team can help you navigate the compliance requirements and evaluate your strategic options.
Frequently Asked Questions
How quickly do I need a new 409A after a down round?
Best practice is to complete a valuation update shortly upon closing the round, and certainly before issuing new options. The sooner you update, the sooner you can make confident decisions about new grants and strategic options.
Will my 409A always drop after a down round?
In most cases, yes. The down round signals market conditions value your company lower. However, the exact decline depends on your appraiser's methodology and company-specific factors. The drop isn't automatic or proportional to the preferred stock price change.
Can I keep issuing options at the old (higher) strike price?
Yes, as long as the strike price is at or above the new 409A fair market value. This "flat" strike pricing approach is common for preserving perceived value on new grants. It doesn't address existing underwater options, but it prevents the problem from getting worse for new grants.
What happens if I don't update the 409A?
Without an updated valuation reflecting the material event, you may lose safe harbor protection. Employees could face immediate taxation of vested options plus a 20% penalty tax plus interest if the IRS determines options were granted below fair market value. The compliance exposure grows with every option granted at potentially incorrect strike prices.
How much does a 409A valuation update cost?
Typically $4,000-$10,000+ depending on company size and complexity. Strategic options like repricing involve additional costs for legal, valuation, and accounting work.
About Redwood: Redwood Valuation provides IRS-compliant 409A valuations for private companies navigating complex equity events, including down rounds and recapitalizations. We work with venture-backed companies at all stages to deliver independent, audit-defensible valuations that reflect current market conditions, capital structure complexity, and employee equity implications. Our reports are prepared by credentialed appraisers and designed to support compliance, informed decision-making, and clear communication with employees, auditors, and other stakeholders.
Learn more about our 409A services | Schedule a consultation | When in doubt, please reach out.