Equity
What Happens to Your Stock Options When Your Startup Is Acquired
When a startup is acquired, options get cashed out, rolled over, or cancelled. The Section 424(a) ratio test decides which rollovers survive the tax code.
By 409.AI Team - 2026-09-16
# What Happens to Your Stock Options When Your Startup Is Acquired
Acquirers spent at least $119.8 billion buying private, venture-backed companies in the first half of 2026, a pace that puts the year ahead of 2025's record, [according to Crunchbase News](https://news.crunchbase.com/ma/2026-mergers-acquisitions-record-cursor-spcx/). For most startup employees, an acquisition is the only liquidity event their options will ever see. It is also the moment they discover that the equity plan never promised them anything in particular.
Most plans hand the board a menu rather than a rule. The board can have the buyer assume the outstanding options, substitute new options over the buyer's stock, cash them out, or cancel them. Vested and unvested grants often get different answers inside the same deal, and the answer lands in the merger agreement rather than in any conversation with the option holders.
Cash-out and cancellation are easy to explain. Assumption and substitution, the two versions of a rollover, run through a piece of the tax code that nobody reads until it has already gone wrong.
Cash-out: the clean one, with a tax bill attached
In a cash deal, the usual treatment is a cancellation payment: shares times the excess of the per-share merger consideration for common stock over the strike price, paid at closing, less applicable withholding. An employee with 20,000 vested options at a $1.00 strike, in a deal paying $4.00 a share to common, receives $60,000 gross.
That payment is ordinary compensation income, and this is true whether the grant was an NSO or an ISO. ISO treatment under [Section 422](https://www.law.cornell.edu/uscode/text/26/422) depends on acquiring shares and holding them through two separate periods. Cancel the option for cash and the holder never acquires a share, so the favorable treatment never attaches. Morgan Lewis makes the point plainly in its survey of [equity awards in corporate transactions](https://www.morganlewis.com/pubs/2024/05/corporate-transactions-considerations-for-addressing-equity-awards): a cashed-out ISO and a cashed-out NSO produce the same ordinary income result. If you have been planning around the [difference between ISO and NSO taxation](https://409.ai/articles/iso-vs-nso-how-stock-options-are-taxed), a cash-out erases it.
Two wrinkles catch people. Cash-out proceeds are usually subject to the same escrow and holdback that the selling shareholders face, so a portion arrives twelve or eighteen months later, if at all. And options with a strike above the per-share consideration are underwater, which in most plans means they are cancelled for nothing. That happens more often than founders expect, because the preference stack eats the consideration before common sees a dollar. The math is in our piece on [liquidation preferences and the waterfall](https://409.ai/articles/liquidation-preferences-waterfall-common-stock-exit), and it is the entire story in a [reverse acqui-hire](https://409.ai/articles/reverse-acqui-hire-cap-table-409a-valuation), where the structure can pay the team handsomely and the option pool nothing at all.
Rollover: where Section 424(a) shows up
When the buyer wants to keep the team, it usually converts the options rather than paying them off. The old option over target stock becomes a new option over buyer stock, with the share count and strike price adjusted.
That conversion is governed by Section 424(a) of the tax code, and [Treasury Regulation 1.424-1(a)](https://www.law.cornell.edu/cfr/text/26/1.424-1) sets out three conditions it has to clear. The new or assumed option must not give the holder "additional benefits that the optionee did not have under the old option." The aggregate spread cannot grow: the excess of aggregate fair market value over aggregate option price immediately after the change must not exceed what it was immediately before. And the ratio of option price to fair market value per share afterward must not be "more favorable to the optionee" than the ratio before.
Get all three right and the substitution is not a new grant. Get them wrong and it is.
The tests, with numbers
Say Northwind's latest 409A puts its common at $4.00. Our employee holds 20,000 vested options at a $1.00 strike. Aggregate fair market value is $80,000, aggregate option price is $20,000, so the spread is $60,000 and the price-to-value ratio is 0.25.
Halcyon, the buyer, is privately held, and its own 409A puts its common at $10.00. The deal converts each Northwind common share into 0.4 Halcyon shares, so the 20,000 options become 8,000. The strike has to satisfy the ratio test: strike divided by $10.00 cannot be below 0.25, so the strike cannot go below $2.50.
Set it at $2.50 and both tests land exactly. Aggregate value after is 8,000 times $10.00, or $80,000. Aggregate option price is $20,000. Spread is $60,000, unchanged. Ratio is 0.25, unchanged. The rollover holds.
Now suppose Halcyon's 409A is nine months old and its common is really worth $12.00 at closing. The same 8,000 options at $2.50 now carry a ratio of 0.208, which is more favorable than the 0.25 the employee started with, and a spread of $76,000, which is larger than the $60,000 before. Both tests fail. To fix it you need a strike of at least $3.00, or fewer shares, and either change has to be made before closing, not discovered in an audit two years later.
The tests only cut one way
This is the part that gets missed. Section 424(a) caps the benefit; it does not guarantee it. A spread that shrinks in the conversion passes both tests without complaint. Only a spread that grows fails.
So the two errors are not symmetric. Value the buyer's common too high and employees quietly receive less than they should, with no tax consequence to anyone. Value it too low and the conversion fails, taking the tax treatment down with it. That asymmetry is exactly why the buyer's common stock valuation matters in a private-to-private deal, where there is no public price to anchor to and the exchange ratio is often set off the last preferred round rather than off common. Preferred price is not common fair market value, a gap covered in [why safe harbor depends on the appraisal rather than the price tag](https://409.ai/articles/409a-safe-harbor-price-vs-qualified-appraiser). A current, defensible [409A valuation](https://409.ai/products/409a) of the acquirer's common is what makes the ratio test provable.
It is not only an ISO rule
Plenty of deal teams treat Section 424 as an ISO housekeeping item. It is not. Under [Treasury Regulation 1.409A-1(b)(5)(v)(D)](https://www.law.cornell.edu/cfr/text/26/1.409A-1), a substitution or assumption of a stock right in a corporate transaction escapes being treated as a new grant only "if the requirements of § 1.424-1 would be met if the stock right were a statutory option." The same tests, applied to NSOs.
Miss them on an ISO and the holder loses ISO status, which is unpleasant. Miss them on an NSO and you have granted a fresh option with a strike below fair market value, which is not exempt from Section 409A at all. The holder faces income inclusion as the award vests, an additional 20% tax, and premium interest. A rollover that was supposed to retain people becomes a penalty they pay for staying.
While you are re-running the numbers, the [$100,000 ISO limit](https://409.ai/articles/iso-100k-limit-409a-grant-date-fair-market-value) deserves a second look too, since the conversion changes the share counts feeding it.
The buyer's accounting splits the award in two
On the company side, replacement awards are not a single expense. Under ASC 805, the fair value of the replacement is allocated between service already rendered and service still to come. The portion attributable to pre-combination service is part of the consideration transferred for the business. The portion attributable to post-combination service is compensation cost in the buyer's income statement, as is any excess of the replacement award's fair value over the original. PwC's guidance on [exchanges of share-based awards in business combinations](https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/business_combination/business_combination__28_US/chapter_3_employee_c_US/34_exchange_of_emplo_US.html) walks the allocation through.
Both sides of that split require an option fair value at the acquisition date, which means the [Black-Scholes inputs for a private company](https://409.ai/articles/black-scholes-inputs-private-company-stock-options) have to be rebuilt on the deal's timeline rather than the annual one. And the consideration piece flows straight into the [purchase price allocation](https://409.ai/articles/asc-805-purchase-price-allocation-startup-acquisition), so an award nobody modeled can move the goodwill number.
Acceleration brings its own problem
Many plans accelerate vesting on a change of control, either outright or on a double trigger. Employees like it. It is also the single most common way a startup deal walks into [Section 280G](https://409.ai/articles/section-280g-golden-parachute-startup-exit-shareholder-vote), where parachute payments above a threshold draw a 20% excise tax on the recipient and a lost deduction for the company. Most private companies can clear it with a shareholder vote, but the vote has requirements and a timeline, and it needs an option valuation of its own.
What to ask before the agreement is signed
If you run finance at a company being acquired, three questions decide most of the outcome for your team. Which grants are being assumed, cashed out, or cancelled, and is the split the same for vested and unvested? If options are rolling over, what fair market value is the buyer using for its own common stock at closing, and how recent is it? And has anyone run the 280G numbers on the acceleration the plan triggers automatically?
The rollover math is the one nobody volunteers. A conversion ratio derived from headline deal value looks reasonable in a term sheet and fails a test written in per-share fair market value. The fix costs a valuation and an afternoon before closing. The alternative is explaining to your engineering team, after the fact, why the options they rolled over now carry a 20% tax they did not agree to.
*This article is general information about how equity awards are treated in acquisitions, not tax or legal advice for any specific transaction. Talk to your own counsel and accountants about your deal.*