409A Valuation FAQ

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

If options are granted below FMV, they are considered discounted options and trigger immediate tax consequences for recipients under Section 409A, including income tax on vesting, a 20% penalty tax, and interest penalties.

The 409A valuation provides a safe harbor, meaning if the company follows proper valuation procedures and the IRS later disagrees with the valuation, the company can defend its position. Most startups obtain their first 409A valuation before granting any stock options, typically shortly after incorporation or before hiring employees who will receive equity compensation.

Companies should update their 409A valuation at least every 12 months to maintain safe harbor protection. However, a material event that significantly affects the company's value requires an updated valuation before granting new options, regardless of when the last valuation occurred.

Material events include:

• Closing a new funding round
• Significant changes in financial performance or projections
• Launching a major product or entering new markets
• M&A discussions or term sheets
• Significant changes in the competitive landscape
• Major customer wins or losses

After a priced funding round, many companies immediately obtain a new 409A because the round establishes a clear data point for preferred stock value that typically increases common stock value. Best practice is to budget for 2-4 409A valuations per year for actively fundraising companies, and at minimum annually for stable companies.

409A valuations typically employ three primary valuation approaches:

• Market Approach: Compares the company to similar publicly traded companies or recent M&A transactions, applying relevant multiples (revenue, EBITDA, etc.) to the subject company's metrics
• Income Approach: Projects future cash flows and discounts them to present value using a discount rate reflecting the company's risk profile; this includes discounted cash flow (DCF) analysis
• Asset Approach: Values the company based on its net asset value, typically used for holding companies or asset-heavy businesses

For startups, valuations also apply the Option Pricing Method (OPM) or Probability-Weighted Expected Return Method (PWERM) to allocate enterprise value among different share classes. A Discount for Lack of Marketability (DLOM) is applied because private company stock cannot be easily sold.

The valuation report must document the methods used, assumptions made, and rationale for conclusions to satisfy safe harbor requirements.

Granting stock options below fair market value (discounted options) triggers severe tax penalties under Section 409A for option recipients:

• The spread between the low strike price and FMV becomes taxable as ordinary income when options vest (not when exercised), even though the employee has received no cash
• A 20% additional federal penalty tax applies on top of regular income tax
• Interest penalties accrue from the date of vesting at the underpayment rate plus 1%
• State penalties may also apply; California imposes an additional 20% penalty

These penalties fall on the employee, not the company, creating significant liability that employees may seek to recover from the company. Companies may face securities law issues, employment claims, and reputational damage. The company is responsible for tax withholding and reporting, even for penalties.

Remediation options are limited; the IRS has offered correction programs, but they require prompt action and may not eliminate all penalties. Prevention through proper 409A valuations is far preferable to remediation.

The IRS provides safe harbor protection for 409A valuations, meaning the valuation is presumed reasonable unless the IRS can prove it was grossly unreasonable. There are three safe harbor methods:

• Independent Appraisal Safe Harbor: A valuation performed by a qualified independent appraiser with significant knowledge, experience, education, and training in business valuations. The valuation must be performed within 12 months of the option grant and no material events can have occurred since the valuation
• Start-Up Company Safe Harbor: Companies less than 10 years old with no publicly traded stock can perform internal valuations if done by someone with significant knowledge and experience, using reasonable methods, and documented in writing. This is less protective than the independent appraisal safe harbor
• Binding Formula Safe Harbor: Applies when stock is subject to a binding buy-sell agreement using a formula price, though this rarely applies to option grants

Most venture-backed startups use the independent appraisal safe harbor to maximize protection.

A 409A valuation and a venture capital financing valuation serve different purposes and typically produce different values.

VC valuations (pre-money and post-money) represent the price investors pay for preferred stock, which has additional rights like liquidation preferences, anti-dilution protection, and board seats. These valuations reflect negotiated deal terms between sophisticated parties and include a premium for these preferential rights.

409A valuations determine the fair market value of common stock, which lacks preferential rights and is less liquid. Common stock is valued lower than preferred stock due to these differences, typically 25-50% of the preferred price for early-stage companies (though this ratio increases as companies mature and approach liquidity).

The 409A valuation allocates enterprise value between preferred and common stockholders using methods like the Option Pricing Method or Probability-Weighted Expected Return Method. A company might raise a Series A at a $10M pre-money valuation but have a 409A common stock value of $0.50 per share compared to the preferred price of $1.50 per share.

To qualify for the independent appraisal safe harbor, a 409A valuation must be performed by a qualified person or firm with significant knowledge, experience, education, and training in performing similar valuations. This typically means:

• Accredited valuation professionals with credentials such as ASA (Accredited Senior Appraiser), CFA (Chartered Financial Analyst), ABV (Accredited in Business Valuation), or CVA (Certified Valuation Analyst)
• Independent valuation firms specializing in 409A valuations for startups
• Accounting firms with valuation practices
• Investment banks (though typically too expensive for routine 409A work)

The appraiser must be independent, meaning they cannot have a material financial interest in the company being valued. Independence ensures objectivity and supports the safe harbor defense.

Early-stage startups often use specialized 409A providers offering valuations for $1,000-5,000, while complex valuations for later-stage companies may cost $10,000-30,000 or more. Internal valuations may qualify under the start-up safe harbor but offer less protection if challenged.

Companies must provide comprehensive information to support an accurate 409A valuation:

• Financial information: Historical financial statements, current financial projections, revenue and expense details, cash position and burn rate
• Capitalization details: Cap table showing all stockholders, option pool details, outstanding convertible instruments (SAFEs, notes), any recent secondary transactions
• Corporate documents: Certificate of incorporation, stockholders agreements, recent board meeting minutes, any term sheets or M&A discussions
• Business information: Company background and history, products and services, market analysis and competitive landscape, customer information, management team background
• Recent transactions: Any recent funding rounds with term sheets and closing documents, secondary sales, tender offers or buyback programs
• Material events: Recent significant contracts, product launches, regulatory changes, litigation, or any other events affecting company value

The valuation firm will also typically interview management to understand the business and validate the information provided.