409A Valuation

A 409A valuation is an independent appraisal of a private company’s fair market value, named after IRS Section 409A. The valuation legally establishes the strike price for employee stock options and determines whether option holders face unintended tax consequences. Without a credible 409A valuation, the IRS may challenge the option strike price, retroactively tax employees on day-one compensation, and expose the company to liability.

Why it exists: preventing option income-shifting

When a private company grants options at a price significantly below what an independent party would say the company is “worth,” the IRS treats the discount as disguised compensation. Instead of the employee paying tax only when they exercise (or sell) the options years later, the IRS can argue that compensation income arose on the grant date itself.

Example: A startup is valued at $100 million in a Series A funding round. The day after closing, the company grants options at a strike price of $0.10 per share, valuing the company at $10 million. The gap between the Series A valuation ($100 million) and the option strike ($10 million) is enormous and indefensible. The IRS would say the employee received compensation of the difference—$90 million per 1,000-share grant—on day one, and owes income tax on $90 million of phantom income. The employee now owes six-figure tax bills despite owning illiquid options and having no cash to pay.

Section 409A was enacted to prevent this abuse. It requires that deferred compensation—which includes option strike prices—be set at fair market value. If you grant options at anything less than a credible, independent appraisal of the company’s value, you are in violation, and the IRS can impose a 20% excise tax on the difference plus penalties and interest.

The three methods: market, cost, or income approaches

A 409A valuation typically uses one of three approaches, depending on what data is available:

Market approach: Comparable companies. What did similar private companies (by stage, industry, growth rate, profitability) sell for recently? A Series B biotech startup might be valued by reference to other Series B biotech acquisitions or Series B funding rounds. This is the gold standard when clean comparables exist.

Cost approach: Asset-based valuation. What is the cost to replicate the company’s assets, adjusted for obsolescence and intangibles? This method is rarely used for going-concern startups (it tends to undervalue them) but is useful for asset-heavy or mature companies.

Income approach: Discounted cash flow or earnings multiple. Project future cash flows, discount them to present value, and that is fair market value. This method is heavily dependent on growth assumptions and is most credible for mature companies with stable, predictable cash flows.

For a typical venture-backed startup, the valuation firm applies the market approach, checking recent funding rounds, secondary transactions, and comparable exits to arrive at a range. If a company just raised a Series B at $75 million post-money valuation, the 409A will typically land at or near that figure (possibly slightly lower if time has passed and dilution has occurred). If the company is pre-funding or between rounds, the valuation firm must dig deeper, using venture capital market multiples and comparables.

The “safe harbor” rule and post-funding timing

The IRS gives companies a safe harbor: if you obtain a 409A valuation within 120 days of a bona fide equity raise (Series A, B, C, etc.), and your option strike is set at or above the valuation, the IRS will not challenge the strike price on the basis of fair market value. The strike price is deemed reasonable if backed by a credible valuation.

This is why venture-backed companies almost always order a 409A valuation immediately after closing a funding round. The timing is cheap insurance: the valuation firm is already engaged for due diligence or accounting purposes, and the 409A adds little incremental cost. Setting option strikes at the post-money valuation from the fund raise is the standard practice and the most defensible approach.

For bootstrapped or pre-revenue companies, or those between funding rounds, obtaining a 409A is more discretionary but still advisable if you are granting options. The valuation firm must rely more heavily on comparables and forward projections, and the resulting valuation is wider in range. But having some credible independent appraisal is far better than relying on management’s guess or the price from the last funding round (which may be stale by years).

What a valuation firm actually does

A reputable 409A valuation firm:

• Requests financial statements, cap table, and business plans.
• Researches comparable companies (acquisitions, funding rounds, public comps).
• Interviews management on growth, profitability, and market position.
• Applies discounts for illiquidity, minority stake, and key-person risk specific to the company.
• Documents assumptions and calculations in a written report.
• Charges $5,000–$15,000 for a single valuation, or higher for complex situations (spin-offs, multiple share classes, conversion scenarios).

The best firms are experienced in your industry and can cite the methodology and comparable deals. Some investors or venture firms have preferred 409A providers they recommend; using a familiar firm may reduce back-and-forth and align expectations.

Illiquidity and discount rates

One critical aspect: 409A valuations explicitly discount for the fact that private company shares are illiquid and cannot be sold at will. A company worth $100 million based on recent funding may have a slightly lower 409A fair market value—say, $90 million—because there is no public market to liquefy shares. This illiquidity discount typically ranges from 0–30%, depending on how close the company is to a liquidity event (IPO, acquisition) and how restrictive the shareholders’ agreement is.

In recent years, as secondary markets for private equity have expanded, illiquidity discounts have shrunk. If a company’s shares trade regularly on platforms like Forge or EquityZen, the discount is minimal. For a pre-revenue startup with no secondary market, the discount is steeper.

Post-strike changes: the “reset” or “repricing” question

If a 409A valuation sets the strike price, but the company’s value drops sharply (recession, product failure, founder departure), should the company issue new grants at a lower 409A valuation? Yes, but with caution. Lowering strike prices on existing options (a repricing) triggers adverse tax consequences and may require shareholder approval. Issuing new grants at a new, lower 409A valuation is routine and tax-neutral. The old options remain at the old, higher strike—they are now underwater and less attractive, which is the unfortunate tax consequence of the downturn.

Conversely, if the company appreciates dramatically between funding rounds, the old 409A valuation is stale, but the company cannot simply issue options at the old price. A new 409A valuation reflecting the new, higher value is required. Using the old valuation would violate Section 409A.

Consequences of skipping a 409A valuation

Some early-stage founders skip the 409A process, thinking it is overkill or too expensive. The risks:

• Retroactive taxation: If the IRS audits and determines the strike price was below fair market value, employees can face unexpected ordinary income tax bills on the “spread” between strike and fair market value.
• Excise tax: The company itself may owe a 20% excise tax on the amount by which the option spread exceeds safe harbor limits.
• Recruiting friction: Sophisticated employees and investors will ask for proof of a 409A valuation before accepting grants. A credible 409A is now table-stakes for any company serious about equity compensation.
• Exit complications: Acquirers and IPO underwriters will request the 409A valuation as part of due diligence. If none exists, they may discount the value of equity grants or require reps and warranties about tax compliance.

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