What is a 409A Valuation?

An independent appraisal of a company's common stock fair market value, required for setting stock option strike prices in compliance with IRS regulations.

Key Takeaways

•409A valuations determine fair market value of common stock for option pricing
•Required by IRS to avoid deferred compensation penalties
•Must be updated annually and after 'material events' like funding rounds
•Provides 'safe harbor' protection when done by qualified appraisers

409A Valuation Definition

A 409A valuation is an independent appraisal of a private company's common stock fair market value (FMV). Named after Section 409A of the Internal Revenue Code, this valuation is used to set the exercise price (strike price) for stock options granted to employees.

Section 409A requires that stock options be granted at fair market value to avoid being treated as "deferred compensation" subject to immediate taxation and penalties. A proper 409A valuation provides "safe harbor" protection—a presumption that the strike price is correct.

Why 409A Valuations Matter

IRS Compliance

Stock options priced below FMV trigger deferred compensation rules with severe tax penalties for option holders.

Employee Protection

Proper valuations protect employees from unexpected tax bills that can reach 20% penalty plus interest.

Safe Harbor

Independent appraisals create a presumption of correctness, shifting burden of proof to the IRS.

Option Value

Lower (but accurate) 409A valuations mean employees get options with more upside potential.

How 409A Valuations Work

409A valuations determine common stock value, which differs from what investors pay for preferred stock:

Common Stock Discount

If your last funding round valued preferred stock at $10/share, common stock might be valued at $2-4/share in the 409A. Why?

Liquidation preferences: Preferred shareholders get paid first in an exit
Lack of marketability: Common stock can't be easily sold
Control and voting rights: Preferred may have superior rights
Anti-dilution protection: Preferred shareholders are better protected

Common Valuation Methods

Option Pricing Model (OPM)

Treats equity like a call option. Models how value flows to different share classes at various exit values. Common for early-stage companies with complex capital structures.

Probability-Weighted Expected Return (PWERM)

Estimates value under different exit scenarios (IPO, acquisition, continued operation) and weights by probability. More work but can be more accurate for later-stage companies.

Market/Backsolve Approach

Uses a recent funding round to imply common stock value. The most common approach shortly after a priced round.

When You Need a 409A Valuation

Before granting any options: Get a 409A before your first option grant
At least annually: Valuations are valid for up to 12 months if no material events occur
After a financing round: New investment resets fair market value
After significant revenue changes: Doubling revenue may trigger an update
After material contracts: Major customer wins/losses
Before an acquisition: May need updated valuation for options granted close to deal

Stale Valuations Create Risk

Options granted under an outdated 409A (especially after a funding round) may be considered granted below fair market value. This creates tax problems for employees and cleanup headaches for the company.

Consequences of Non-Compliance

If stock options are granted below fair market value and don't qualify for safe harbor protection:

Employee Tax Consequences

Immediate taxation: The "spread" (FMV - strike price) is taxable income at grant date, not exercise
20% penalty tax: Additional 20% federal tax on the deferred compensation amount
Interest: Underpayment interest from when tax was due (grant date)
State taxes: Some states have additional penalties

Example Impact

Option grant: 10,000 shares at $0.50 strike when FMV was actually $2.00

Spread: $15,000 | Ordinary income tax (35%): $5,250 | 409A penalty (20%): $3,000 | Plus interest | Total: $8,000+ tax on options not yet exercised

Achieving Safe Harbor Protection

Safe harbor creates a presumption that your valuation is correct. The IRS must prove it's "grossly unreasonable" to challenge it.

Independent Appraisal (Most Common)

Valuation by a qualified independent appraiser with at least 5 years relevant experience. Must have no material relationship with the company.

Illiquid Startup Rule

For companies less than 10 years old with no public trading: board can determine value if using a reasonable valuation method and all relevant information. More risky than independent appraisal.

Frequently Asked Questions

How much does a 409A valuation cost?

Basic 409A valuations range from $1,000-$5,000 for early-stage companies using online providers. Complex companies or established firms may pay $5,000-$15,000+. Some cap table management platforms include 409A as part of their service. The cost is minimal compared to the tax penalties for non-compliance.

How often do I need a new 409A?

At minimum annually, but more frequently if there's a 'material event' like a funding round, major contract win/loss, significant revenue change, or acquisition offer. Many companies refresh quarterly during rapid growth. A stale 409A can invalidate option grants.

Can I issue options without a 409A?

Technically, you can if the board determines fair market value themselves, but this creates significant risk. The 'safe harbor' protection only applies to valuations by qualified independent appraisers. Most startups should get proper 409A valuations before any option grants.

What's the penalty for incorrect option pricing?

Employees receiving options priced below fair market value face immediate tax on the spread (FMV - strike price), plus 20% penalty tax, plus interest. This applies at grant, not exercise. The company may also have reporting and withholding obligations. The costs can be devastating for employees.

Need Help with Equity Compensation?

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