You have likely heard the term thrown around as soon as you started discussing hiring employees or issuing equity. The 409A valuation is a formal appraisal of the fair market value of your company’s common stock.
It is distinct from the valuation investors give you during a fundraising round. Investors are pricing preferred stock. The 409A prices common stock.
The name comes from Section 409A of the Internal Revenue Code. The IRS requires this valuation to ensure that the stock options you grant to employees have a strike price that represents their true fair market value at the time of the grant. If you issue options below this value, the IRS views that difference as immediate income for the employee, which leads to significant tax complications.
The Concept of Safe Harbor
#Founders often ask why they cannot just estimate the price themselves. In the very early days, you might get away with it. However, as soon as you have distinct value or funding, you need a third party.
Using an independent appraiser grants your startup “safe harbor” status. This means the IRS presumes your valuation is correct unless they can prove it is grossly unreasonable.
Without safe harbor, the burden of proof falls on you to prove the price was accurate. If you are wrong, your employees face a 20% federal penalty tax on top of regular taxes. It creates a mess that can ruin your reputation with your team.
When You Need a Valuation
#Compliance is not a one time event. You are required to update your 409A valuation at specific intervals or moments of change.
- Every 12 months: A valuation expires after one year. You cannot issue new options on an expired report.
- Material Events: If you raise a new round of venture capital, the value of the company changes. You need a new appraisal.
- Secondary Sales: If early employees or founders sell stock to a third party, this changes the known market value of the shares.
Comparing Common vs. Preferred
#It is common for founders to be confused by the difference in numbers. You might raise money at a $10 share price, but your 409A report says your common stock is worth $3.
This is normal. In fact, it is desirable.
Investors hold preferred stock. This comes with rights like liquidation preferences and anti-dilution protection. Common stock, which employees hold, does not have these protections. Therefore, common stock is worth less.
A lower 409A price is actually a benefit to your employees. It gives them a lower strike price. This means they can buy their shares cheaper in the future, increasing the spread between their cost and the eventual exit value.
The Science and the Unknowns
#Valuation firms use various methodologies such as the Black-Scholes model or the Option Pricing Method (OPM). They look at your cash position, revenue projections, and comparable public companies.
However, it is worth noting that valuation is never an exact science. It is a defensible estimate based on available data. We often do not know exactly how the IRS will weigh certain futuristic projections in an audit years down the road, which is why sticking to the standard methodologies provided by reputable firms is the safest path for a growing business.