409A Valuations Explained (Deep Dive): Implications for Employees and Founders
Your 409A valuation determines strike prices for options. Get it wrong, and employees face surprise tax bills. Get it right, and everyone understands the value they're receiving.
Your Series A just closed at $10M valuation. Perfect—your 409A valuation is $10M, right? No. If your Series A values the company at $10M, your 409A should reflect that a month before the Series A closed. If you wait to get a 409A after your Series A, you've waited too long.
Timing matters because 409A valuations determine strike prices for options. If the valuation is too low, employees owe taxes on options they can't exercise. If it's too high, the strike price is too expensive and employees feel cheated.
409A Is IRS Requirement
You must have a 409A valuation to grant options. It's required by the IRS. Without it, you face penalties and employees face unexpected tax liability.
When to Update 409A
Update your 409A in these situations:
- Every 12 months: Annual update to reflect current company value
- Before major funding: Update 2-4 weeks before closing Series A/B/C
- After major events: Acquisition, major contract, significant revenue milestone
- Before large grants: Don't grant options without a recent 409A
The Timing Trap
Problem: You close Series A on Day 1 at $10M. You get 409A done on Day 15 at $12M (because more recent data). Now option strikes are $12/share, but the Series A investors bought at a $10M valuation. Options are underwater—employees feel cheated.
Solution: Get 409A done before the Series A closes. Lock in the valuation that matches investor pricing.
409A Valuation Methods
Three standard approaches (in order of most to least conservative):
Method 1: Income Approach
Value based on projected future cash flows discounted to present value. Most favorable to employees (lower valuation = lower strike prices).
Method 2: Market Approach
Compare your company to similar public/private companies. Most common for funded startups.
Method 3: Asset Approach
Value based on balance sheet assets. Least common for early-stage.
The Valuation Tension
You want a conservative (low) 409A to give employees cheap options. But investors want a realistic valuation. Professional firms balance this fairly.
AMT Planning for ISOs
AMT = Alternative Minimum Tax. It's a tax trap for employees who exercise ISOs when the company is worth a lot but not yet liquid.
How AMT Works
- You exercise 10,000 ISOs at $2/share strike ($20K cost)
- Company is now valued at $10/share (409A valuation)
- The $8/share spread is "income" for AMT: $80K
- You owe AMT on the $80K spread, even if you don't sell the stock
- AMT can be 20%+, so you might owe $16K in taxes with no liquid stock
This is a killer for employees. They exercise options expecting upside, then owe tens of thousands in taxes before the company is acquired or goes public.
Pro tip for founders: Be conservative with 409A valuations in early years. Don't jump the strike price too high too fast. Give employees breathing room.
409A Timing Strategy by Stage
Seed Stage
Get a 409A before you grant options. Cost: $2-4K. Use conservative income approach. You want low strike prices to make options attractive.
Series A
Update 409A 2-4 weeks before Series A closes. Coordinate with investors on valuation. They'll expect your 409A to match their proposed pre-money.
Series B+
Annual updates. Each round, do a fresh 409A before closing. Cost: $3-5K per update. Worth it to avoid tax surprises.
Common 409A Mistakes
Mistake #1: No 409A at All
You grant options with no 409A valuation. Employees face surprise tax bills. Series A investors are horrified and require remediation.
Mistake #2: 409A After Funding Closes
You close Series A at $8M pre, then get 409A at $12M valuation (based on more recent revenue). Strike prices are underwater relative to investor pricing.
Mistake #3: Not Updating for Years
Your last 409A was at $2M pre. Company is now worth $20M. You finally update the 409A. Employees owe massive AMT on the gap.
409A Implementation Checklist
Get Initial 409A Before Granting Options
Hire a firm like Carta or Pulley. Cost $2-4K. Don't skip this.
Update Before Major Funding
2-4 weeks before Series A/B/C closes. Coordinate valuation with investors.
Annual Refresh
Update 409A every 12 months even if not fundraising.
Communicate Strike Prices
Explain to employees what their strike price means and potential tax impact.
Need help with 409A timing?
409A valuations are complex but critical. At Eagle Rock CFO, we help you coordinate 409A timing with fundraising and ensure strike prices align with investor valuations.