Legal & Compliance
What is a 409A valuation?
A 409A is an independent appraisal of a private company's fair market value (FMV). It's required by the IRS to set the exercise price of employee stock options — options must be priced at or above FMV to avoid tax penalties.
Section 409A of the Internal Revenue Code requires that stock options issued to employees be priced at fair market value at the time of grant. To establish what that FMV is, companies hire an independent third-party appraiser to conduct a 409A valuation.
A 409A valuation is different from a VC-round valuation. VC investors invest in preferred stock, which has liquidation preferences and other rights that make it more valuable than common stock. Employees receive common stock options, which are worth less. The 409A methodology accounts for this — common stock FMV is typically a significant discount to the preferred price.
For example: a company might raise a Series A at a $30M pre-money valuation (preferred stock). But the 409A might put common stock FMV at $10M — a one-third discount — reflecting the liquidation preference stack.
Companies should get a new 409A: - Annually (as a safe harbor) - Within 12 months of the previous one - After a material event (funding round, acquisition offer, major revenue milestone) that could affect FMV
The "safe harbor" protection under 409A means that if you use an independent appraiser and follow the methodology, the IRS presumptively accepts the valuation. Issuing options without a valid 409A exposes employees to severe tax penalties — the full value of the option is immediately taxable, plus a 20% penalty.