A 409A valuation is an IRS-required independent appraisal of a private company’s common stock fair market value (FMV). It’s used to set the strike price of stock options and must comply with Internal Revenue Code Section 409A.

Why 409A exists

Before 409A (enacted 2004), companies could grant options at discounted strike prices, creating deferred compensation that the IRS wanted taxed. 409A enforces FMV-based strike pricing to prevent tax arbitrage.

When you need a 409A

• Before issuing options for the first time.
• At least annually to maintain “safe harbor” status.
• After material events: Priced rounds, acquisitions, revenue inflection, strategic pivots.

Valuation methodologies

1. OPM (Option Pricing Model): Treats equity as a series of options on enterprise value; accounts for preference stack.
2. PWERM (Probability-Weighted Expected Return Method): Models multiple exit scenarios and weights them.
3. Current Value Method: Simple allocation of current equity; used for distressed companies.
4. Hybrid methods: Combine OPM + scenarios.

How preferences affect 409A

• Higher preferences → lower common FMV: If preferred shareholders get a bigger cut at exit, common value drops.
• Recent priced round → primary anchor: A priced round sets the preferred share value; common is derived with a discount.

Typical FMV as % of last round’s preferred price

• Early-stage (seed): 20–40% of preferred share price.
• Growth-stage: 40–70%.
• Late-stage / pre-IPO: 70–90%.

Safe harbor provisions

If the 409A is performed by a qualified independent appraiser using a reasonable methodology, the IRS presumes it’s correct. Otherwise, the burden of proof shifts to the company.

Common 409A scenarios

1. Company raises a priced round: Refresh 409A within 60–90 days.
2. Significant revenue milestone: Refresh if it meaningfully changes fundamentals.
3. Planning an option grant: Ensure latest 409A is under 12 months old.
4. Down round occurs: Refresh; common FMV usually drops.

What founders need to do

1. Engage a qualified appraiser (Carta, Pulley, AngelList Valuations, Aranca, Scalar).
2. Provide financials and forecast — transparent is better than optimistic.
3. Disclose preference stack completely.
4. Document the valuation in board minutes and option grants.

Penalties for non-compliance

• Immediate income recognition on the spread between FMV and strike.
• 20% additional federal tax.
• State penalties (California adds additional tax).
• Interest charges.

This can make a well-intentioned option grant into a five-figure tax nightmare for employees.

Practical takeaway

1. Founders: Never grant options without a valid 409A covering the grant date.
2. Employees: Ask for the 409A date and strike price when negotiating.
3. Investors: Confirm 409A hygiene in due diligence — sloppy grants can void the option plan.

Further reading

• IRS 409A guidance: https://www.irs.gov/irm/part4/irm_04-041-012
• Carta 409A overview: https://carta.com/learn/startups/409a-valuations/