Compliance

Down Rounds and Underwater Options: What Happens to Your 409A, and How to Reprice the Right Way

A down round resets your 409A and pushes employee options underwater. Here's what changes, and how to reprice without tripping 409A, ISO, and ASC 718 rules.

By 409.AI Team - 2026-07-21

# Down Rounds and Underwater Options: What Happens to Your 409A, and How to Reprice the Right Way

A down round used to be the thing nobody said out loud on a founder call. Somewhere between the 2021 peak and the reset that followed, it turned into a normal line in board decks. Plenty of companies that raised at a rich valuation in 2021 or 2022 have since priced a round lower, and the pain doesn't stop at the term sheet. It lands on the cap table, where the options your team is counting on can quietly become worth less than the cash it would take to exercise them.

Those are underwater options. Cleaning them up touches three things at once: your 409A valuation, your stock-based compensation accounting, and your employees' tax picture. Get the sequence wrong and a well-meaning retention fix can create a compliance mess. Here's what actually changes when the round goes down, and how to reprice without breaking the rules that make options worth granting in the first place.

A down round is a material event

Your 409A is not a number you set once a year and forget. It comes with a safe harbor: the IRS presumes the value is reasonable for up to 12 months from the valuation date, as long as nothing material happens in between. A new priced financing is about as material as events get, so closing one restarts that clock whether the round is up, flat, or down. If you want the full list of triggers that force an early refresh, we walked through them in [how often you actually need a 409A](https://www.409.ai/articles/409a-valuation-frequency-how-often-should-you-get-one).

A down round is the version of that trigger founders dread. The new preferred price is lower, the implied equity value is lower, and a fresh appraisal will almost always pull your common stock's fair market value down with it. The gap between your headline valuation and your common FMV exists even in good times, mostly because preferred shareholders sit ahead of common in a liquidation and because private common carries a discount for lack of marketability. We unpacked that structural gap in [why your 409A comes in below your post-money](https://www.409.ai/articles/why-is-your-409a-valuation-lower-than-post-money-valuation). A down round widens it from both ends: the starting price is lower, and down-round financings often come with heavier liquidation preferences or anti-dilution protection that push common down further still.

Why options end up underwater

Say your team got options in early 2022 with a $2.00 strike, set off a 409A that reflected the valuation at the time. Two years later you raise a bridge at a lower price, and the refreshed 409A puts common fair market value at $0.80. Every option granted at $2.00 is now underwater by $1.20. Nobody exercises an option to pay $2.00 for a share currently appraised at $0.80, so those grants stop doing the one job they were issued to do, which is keep people motivated to stay.

Worth saying clearly, because it worries employees: being underwater is not a taxable event. Your team owes nothing simply because the strike now sits above fair market value, and the options still carry time value as long as the company can grow back into and past that strike. The problem is psychological and competitive, not immediate and fiscal. A new hire down the hall may be getting a fresh grant struck at $0.80, and the person who joined two years earlier is staring at a strike more than double that.

The four ways companies respond

There's no single fix, and the right one depends on how deep underwater the options sit and how your team reads the situation. In practice, boards weigh four moves.

The lightest touch is to leave existing grants alone and issue new options at the current, lower strike, sometimes as a top-up to the people most affected. Repricing goes further: you lower the strike on options already outstanding to match today's fair market value. Some companies instead cancel underwater options and grant restricted stock units, which hold value even when option strikes don't. The most aggressive is a cash buyback of underwater grants, which is rare for private companies short on cash. Repricing is the one that founders reach for most, and it's also the one with the most rules attached, so it's worth walking through carefully.

Repricing done right starts with a fresh 409A

To reprice, you reset the strike on outstanding options to current fair market value. The catch is that "current fair market value" has to be defensible, not a number that feels about right. Under Section [409A](https://www.law.cornell.edu/uscode/text/26/409A) of the tax code, a stock option granted with an exercise price below fair market value on the grant date is treated as nonqualified deferred compensation, which drags in income inclusion as it vests plus an additional 20% federal penalty and interest for the option holder. A repricing is a new grant date for this purpose, so the new strike has to be at least the fair market value on the day you reprice.

That's why the sequence matters. You order a 409A refresh, dated at or near the repricing, and you set the new strike to the common fair market value it supports. Skip the appraisal and price it by gut, and you've handed the IRS a reason to argue the option was discounted from day one. If you suspect your existing valuation was off before the down round even hit, sort that out first; we covered how to spot and fix a bad number in [dealing with an incorrect 409A valuation](https://www.409.ai/articles/dealing-with-incorrect-409a-valuations).

The accounting: repricing is a modification under ASC 718

Lowering a strike price is a modification under ASC 718, the standard that governs how you expense stock-based compensation. That's not a footnote. Modification accounting asks you to value each affected award twice using an option-pricing model such as Black-Scholes, once immediately before the change and once immediately after. Any increase in fair value is incremental compensation cost, and you recognize it on top of whatever expense was already running: immediately for options that are already vested, and over the remaining service period for options that aren't.

Keep the earlier example going. Suppose the Black-Scholes value of an underwater $2.00 option was $0.30 just before the reprice, and the same option restruck at $0.80 is worth $0.55 right after. The $0.25 difference per share is incremental cost you'll book. Multiply that across a big option pool and a repricing that looks free to employees can put a real number through your income statement. If ASC 718 mechanics are new to you, our [guide to expensing stock options under ASC 718](https://www.409.ai/articles/asc-718-stock-based-compensation-startup-guide) lays out how the original grant expense is built before any modification enters the picture. None of this changes cash, but it changes reported results, and your auditors will expect the modification math to tie out.

Watch the ISO traps

Repricing incentive stock options carries a wrinkle that catches teams off guard. For tax purposes, changing the exercise price is treated as the cancellation of the old option and the grant of a new one. That resets the ISO clocks under Section [422](https://www.law.cornell.edu/uscode/text/26/422): the two-year-from-grant and one-year-from-exercise holding periods that qualify a sale for favorable long-term capital gains treatment start over from the repricing date. It also re-runs the $100,000 rule, which says that options first becoming exercisable in a single calendar year lose ISO status on any amount above $100,000 of grant-date value and convert to nonqualified options. A repricing can quietly tip grants over that line.

The upshot is that a move meant to help employees can shift some of them from ISO to NSO treatment, with a different tax outcome on exercise and sale. The difference between the two is exactly the kind of thing worth understanding before you sign off, and we laid it out in [ISO vs. NSO and how each is taxed](https://www.409.ai/articles/iso-vs-nso-how-stock-options-are-taxed). This is the point in the process to bring in a tax advisor and equity counsel rather than to improvise.

If you swap options for RSUs

Some companies decide the cleanest path is to cancel underwater options and grant RSUs, which don't have a strike to be underwater against. Done at scale, that's usually structured as a tender offer to employees, with a filing and disclosure process that resembles the option-for-cash and secondary tender offers we covered in [tender offers and secondary sales](https://www.409.ai/articles/tender-offers-secondary-sales-409a-valuation). RSUs solve the underwater problem, but they trade one set of considerations for another, including how and when the shares get taxed as they vest and settle. Treat an exchange as its own project with legal review, not a quick swap.

What to actually do

If your last round priced down, the practical order is straightforward. Refresh the 409A promptly, since the down round already triggered the need and you'll want a defensible common fair market value on file. Model the ASC 718 hit before you commit to a repricing, so the board sees the expense, not just the retention upside. Loop in tax and equity counsel early on the ISO and Section 409A questions, because those are the details that turn a helpful gesture into a liability. Then communicate the plan to your team in plain terms, because an underwater option that nobody explains does more damage to morale than the down round itself.

A down round is a setback, not a verdict. The companies that handle it well treat the cleanup as a compliance exercise with a fresh valuation at the center, not a favor they can grant on the fly. If you need that valuation refreshed to support a repricing, that's exactly what a [409A valuation](https://www.409.ai/products/409a) is for, and getting it right is what keeps the fix from becoming the next problem.