409A Valuations Explained: What Startups Need to Know
Everything founders need to understand about 409A valuations: what they are, when you need them, how they work, and how to avoid costly compliance mistakes.
If you're planning to grant stock options to employees, you need to understand 409A valuations. Named after Section 409A of the Internal Revenue Code, these valuations determine the "fair market value" (FMV) of your common stock and set the minimum exercise price for your options.
Get it wrong, and your employees could face devastating tax consequences: immediate taxation, penalty taxes, and interest charges that can exceed the value of the options themselves. Get it right, and your equity compensation becomes an incredibly powerful recruiting and retention tool.
This guide explains everything you need to know about 409A valuations, from the basics to the nuances that trip up even experienced founders.
Quick Summary
A 409A valuation is an independent appraisal of your company's common stock fair market value. You need one before granting stock options and after each priced funding round. Typical cost is $1,000-$5,000, and valuations are valid for up to 12 months.
What Is a 409A Valuation?
A 409A valuation is an independent assessment of your company's common stock fair market value. It's used to set the exercise price (also called "strike price") for stock options. The valuation must be performed by an independent third party using recognized valuation methods.
Key Terms to Know
Fair Market Value (FMV)
The price at which property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.
Exercise Price / Strike Price
The price at which an option holder can purchase shares. Must be at least equal to FMV at the time of grant to comply with 409A.
Common Stock vs. Preferred Stock
Investors receive preferred stock with special rights (liquidation preference, anti-dilution, etc.). Employees receive options on common stock, which has fewer rights and is therefore valued lower.
Discount for Lack of Marketability (DLOM)
A reduction applied to account for the fact that private company stock can't be easily sold on a public market. Typically ranges from 20-40% for early-stage startups.
Why 409A Compliance Matters
The consequences of 409A non-compliance fall primarily on your employees—and they're severe. This isn't just about the company; it's about protecting the people who took a chance on your startup.
Consequences of Non-Compliance
If options are granted with an exercise price below FMV:
- Immediate taxation: The employee is taxed on the "spread" (difference between FMV and exercise price) at vesting, even if they haven't exercised
- 20% penalty tax: An additional 20% federal penalty tax on the spread
- Interest charges: Interest on unpaid taxes from the date of vesting
- State penalties: Some states (like California) impose additional penalties
Example: The Real Cost of Non-Compliance
Scenario: An employee receives 10,000 options with an exercise price of $1, but the actual FMV was $3. The "spread" at grant is $2/share = $20,000.
The employee owes $16,000+ in taxes on options they may never exercise—before they've made a dime.
Beyond the direct tax consequences, 409A issues create problems during due diligence for fundraising or M&A. Investors and acquirers will scrutinize your equity grants, and discovered issues can delay or derail deals.
When You Need a 409A
You need a 409A valuation in place before you can grant stock options. The valuation must be current—generally no more than 12 months old and reflecting any material changes to your business.
Mandatory Triggers
Before Your First Option Grant
Get a 409A before granting any options. Don't wait until you've already made promises to employees—get the valuation first.
After Each Priced Funding Round
A new equity financing round is a "material event" that requires a new 409A. Get it done within a reasonable timeframe after closing (typically 30-90 days).
At Least Annually
Even without a funding round, valuations are only valid for 12 months. Plan for annual refreshes if you're continuing to grant options.
After Material Events
Significant business changes may require a new valuation even if the current one isn't expired. Examples include large contract wins, pivots, acquisitions, or key executive changes.
12-Month Safe Harbor
What Is the Safe Harbor?
If your 409A valuation meets certain requirements, it creates a "safe harbor"—a presumption that the valuation is reasonable. The IRS can only challenge it if they prove it was "grossly unreasonable."
To qualify for safe harbor, the valuation must be performed by someone with "significant knowledge and experience" in valuations, done within the previous 12 months, and there must have been no material events since the valuation date.
Valuation Methods
409A valuations use one or more standard valuation methods. The appropriate method depends on your company's stage and available data.
Market Approach
Values the company based on comparable transactions or public companies.
Best for: Companies with clear comparables; post-revenue companies
Methods: Guideline Public Company, Guideline Transaction
Income Approach
Values the company based on expected future cash flows, discounted to present value.
Best for: Companies with predictable revenue; later-stage startups
Methods: Discounted Cash Flow (DCF)
Asset Approach
Values the company based on the value of its assets minus liabilities.
Best for: Asset-heavy businesses; rarely used for tech startups
Methods: Adjusted Book Value
Backsolve Method
Derives common stock value from a recent preferred stock transaction (funding round).
Best for: Recently funded companies; most common for post-priced-round valuations
Methods: Option Pricing Model (OPM) Backsolve
Allocation Methods
Once the total company value is determined, it must be allocated between preferred and common stock. Two methods are common:
| Method | Description | Best For |
|---|---|---|
| Option Pricing Model (OPM) | Treats each security class as an option on enterprise value. Accounts for liquidation preferences and other rights. | Early-stage with uncertain exit; most common |
| Probability Weighted Expected Return (PWERM) | Models multiple exit scenarios (IPO, M&A, liquidation) and weights them by probability. | Later-stage with clearer exit paths |
The 409A Process
Here's what to expect when getting a 409A valuation:
Engage a Provider
Choose a 409A valuation provider (more on this below). Typical timeline: 1-3 weeks for simple valuations, longer for complex cap tables.
Provide Information
You'll need to provide financial statements, cap table, funding documents, business plan, and other relevant information. Cap table management tools often streamline this.
Valuation Analysis
The provider performs their analysis using appropriate methods. They may have follow-up questions about your business, projections, or recent developments.
Draft Report
You'll receive a draft report with the concluded FMV. Review it for accuracy and discuss any questions with the provider.
Final Report
Once finalized, you receive the official 409A report. Keep this on file—you'll need it if the IRS ever audits your equity grants.
What You'll Need to Provide
Financial Information
- - Recent financial statements
- - Financial projections (if available)
- - Monthly revenue data
- - Key metrics (MRR, ARR, etc.)
Cap Table & Legal
- - Current cap table
- - Articles of incorporation
- - Investment documents
- - Option plan documents
Business Information
- - Business description
- - Competitive landscape
- - Key customers/contracts
- - Recent milestones
Market Context
- - Comparable companies
- - Industry trends
- - Exit expectations
- - Risk factors
Common vs Preferred Pricing
One of the most common questions founders have is why the 409A value (common stock) is so much lower than their last funding round price (preferred stock). This isn't a mistake—it's a feature of how startup equity works.
Why Preferred Stock Is Worth More
Liquidation Preference
Preferred stockholders get paid first in an exit. If the company sells for less than expected, common holders may get nothing.
Anti-Dilution Protection
Preferred stock often has price protection if future rounds are at lower valuations. Common stock doesn't.
Dividend Rights
Preferred may have dividend rights that common stock doesn't, though these are rarely paid in practice.
Information Rights
Preferred investors typically get board seats and detailed financial information. Common holders don't.
Typical Common Stock Discount
Common stock typically values at 25-40% of the preferred price for early-stage companies, though this varies based on stage and specific terms.
| Stage | Typical Common/Preferred Ratio |
|---|---|
| Pre-seed / Seed | 15-25% |
| Series A | 25-35% |
| Series B+ | 35-50% |
| Late Stage / Pre-IPO | 50-80% |
Example: If your Series A was at $5/share preferred, common stock might value at $1.50-$1.75/share.
Choosing a Provider
You have several options for 409A valuations, from automated platforms to traditional valuation firms. The right choice depends on your complexity and budget.
Provider Types
Automated Platforms (Carta, Pulley, etc.)
$1,000-$3,000Software-driven valuations with streamlined data collection. Fast, affordable, and typically sufficient for early-stage companies with standard cap tables.
Boutique Valuation Firms
$3,000-$8,000Specialized firms focused on startup valuations. More hands-on than automated platforms, better for complex situations or those wanting more defensibility.
Big Four / Large Firms
$10,000-$25,000+Traditional accounting firms offer valuation services. Most defensible but expensive and often slower. Typically only needed for late-stage or very complex situations.
Our Recommendation
For most seed and Series A startups with standard cap tables, automated platforms like Carta or Pulley are sufficient and cost-effective. If you have unusual terms, secondary transactions, or are approaching later stages, consider a boutique firm.
Common 409A Mistakes
Avoid these common mistakes that create 409A compliance issues:
Granting Options Before Getting a 409A
Never promise or grant options before you have a 409A in place. If you do, you may have to reprice or deal with compliance issues later.
Using an Outdated Valuation
A 409A is only valid for 12 months or until a material event. Granting options after a funding round on the old valuation is a major compliance failure.
Backdating Grant Dates
Grant dates must reflect when the board actually approved the grants. Backdating to get a lower strike price is illegal and creates severe consequences.
Ignoring Material Events
A major business development (big contract, pivot, M&A discussion) can invalidate your current 409A even if it's less than 12 months old.
Not Getting Board Approval
Option grants must be approved by the board (or a duly authorized committee). Informal promises without board action don't constitute valid grants.
Poor Documentation
Keep records of when valuations were obtained, when grants were approved, and the FMV used. You'll need this documentation for audits and due diligence.
What If You've Made a Mistake?
If you've already granted options with potential 409A issues, consult with legal counsel immediately. There may be correction procedures available, especially if caught quickly. The IRS has provided limited relief programs for certain 409A failures.
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Need Help With 409A Compliance?
Eagle Rock CFO can help you navigate 409A requirements, coordinate with valuation providers, and ensure your equity compensation is compliant.
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