What Is a Down Round and Why Does It Affect Your 409A?
A down round occurs when a company raises new funding at a lower per-share price than its most recent previous round — meaning the company's valuation has decreased. Down rounds happen for many reasons: broader market contractions, missed growth targets, changing investor sentiment, or industry-specific headwinds.
For 409A purposes, a down round is a material event that immediately invalidates your existing 409A valuation and requires a new independent appraisal before any new option grants can be made.
How the New 409A Reflects the Down Round
The backsolve method anchors 409A enterprise value to the most recent preferred round price. In a down round, that anchor is now lower — so the entire valuation chain shifts down:
- Lower preferred round price → lower implied enterprise value via backsolve
- Lower enterprise value → less value to allocate to common stock via OPM
- Anti-dilution provisions for existing preferred investors (full ratchet or weighted average) further compress the common stock allocation
- DLOM may increase slightly as uncertainty rises, further reducing common FMV
The result: your new 409A common stock FMV is materially lower than the previous one.
The Underwater Options Problem
Employees who received options at the old (higher) strike price now hold underwater options — options whose strike price exceeds the current FMV. These options have no intrinsic value and may feel worthless to employees, creating a retention and morale crisis.
Example: An employee received 10,000 options at $2.00/share (last round's 409A FMV). Post-down-round, the new 409A sets FMV at $0.80/share. The employee's options are $1.20/share underwater — worth $0 in intrinsic value, and the company must recover to >$2.00 before the employee sees any gain.
Option Repricing: The Solution and Its Costs
Companies often consider repricing underwater options to the new lower 409A FMV to restore employee incentive value. This is legally permitted but comes with significant costs:
Tax Consequences of Repricing
- ISOs: Repriced ISOs are treated as new grants and restart the ISO holding period. If the repriced amount exceeds $100,000 in the year of repricing, the excess converts to NQSOs.
- NQSOs: Repricing must be structured carefully under §409A. A straight exchange (cancel old, grant new at current FMV) is the safest approach. "Value-for-value" exchanges done correctly do not trigger immediate income tax.
Accounting Consequences of Repricing
- Under ASC 718, repricing is treated as a modification. The company must record incremental fair value (the difference between old and new option value) as additional stock-based compensation expense.
- This increases reported SBC expense on the P&L, affecting adjusted EBITDA metrics.
SEC and Board Disclosure
- Repricing requires board approval and typically stockholder approval if the company has a public-company-style equity plan
- All affected employees must consent to the repricing
- Companies with auditors must disclose the repricing and its accounting impact
New Grants After a Down Round: The Silver Lining
For new hires joining after the down round, the lower 409A FMV is actually attractive. Options granted at the new lower strike price have more room to appreciate, which can make new equity grants a stronger recruiting tool than they were at peak valuation. Getting the new 409A done quickly allows you to resume hiring with competitive equity packages.
Down Round 409A Timeline
| Event | Action Required | Timing |
|---|---|---|
| Down round term sheet signed | Pause new option grants immediately | Immediately |
| Down round closes | Engage 409A appraiser | Within 1–5 business days |
| New 409A completed | Board approves new strike price; resume grants | Typically 7–14 days post-close |
| Evaluate repricing | Legal and accounting review; employee communication | Within 30–60 days post-close |