Hello founders!

If you’re thinking about offering stock options to your team, you’ve probably heard whispers about a 409A valuation. Unlike a public company, a startup doesn’t have a market price for its common shares. To set a fair exercise price for employee options, the IRS requires a special appraisal called a 409A valuation. Setting the strike price below the fair market value (FMV) can trigger tax penalties for you and your employees, so getting it right matters!

In this article we’ll break down what a 409A valuation actually is, why it’s so important for startups and when you should refresh yours. We’ll also touch on the different methodologies used and share a few tips to make the process smoother.

What exactly is a 409A valuation?

A 409A valuation is an independent appraisal of the fair market value of a private company’s common stock. This valuation sets the exercise price for stock options and must be at or above FMV. Because private companies don’t have a quoted stock price, the IRS created Section 409A to make sure option grants aren’t priced too low. If you issue options below FMV, your employees could owe extra taxes and penalties.

Why do founders care? Since 2004, getting a 409A valuation is a legal requirement whenever a private company issues stock options or other deferred compensation. It protects you from under or overvaluing your shares, undervaluation hurts employees’ upside, while overvaluation can lead to IRS scrutiny and fines.

Why your startup needs a valuation

Stay compliant and build trust

The IRS requires private companies to document the fair market value (FMV) of their common stock before issuing options. A fresh 409A report provides safe harbor — proof that you made a reasonable effort to set a fair price. Without it, both the company and its employees may face additional taxes or penalties.

Using an outdated valuation can also be risky. If you issue options after a fundraising round without updating your 409A, the IRS may treat the strike price as being below FMV — triggering penalties for both the company and the employee.

A well-supported valuation also helps attract and retain talent: people feel more confident knowing their equity grants are transparent and compliant.

Prepare for growth

409A valuations aren’t a one‑and‑done exercise, you need to do one before your first option grant, and again whenever something meaningful changes in your business, like raising a new round, pivoting your model or acquiring another company. The IRS assumes valuations are valid for 12 months, but early‑stage startups often refresh annually or sooner to stay in safe harbor.

When do you need a new valuation?

• Before granting options for the first time
  
  
• After a fundraising round, secondary sale or major change.
  
  
• When entering a new market or pivoting your product
  
  
• Annually, even without big changes, to maintain safe harbor.
  
  

Some states have their own rules. California, for example, treats many partnerships and LLCs differently, so always check state requirements.

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How 409A valuations are done

There’s no single formula to value a private company. Appraisers use different approaches depending on the stage and nature of the business:

1. Income approach: projects future cash flows and discounts them back to the present at a rate that reflects risk. It’s common for startups with predictable revenue.
   
   
2. Market approach: compares your company to public or recently sold companies in a similar industry. Methods include:
   
   
   
   • Guideline Public Company Method: applies multiples from comparable public companies.
     
     
   • Guideline Transaction Method: uses multiples from actual M&A transactions.
     
     
   • Backsolve Method: infers value from your latest funding round by modelling your cap table.
     
     
3. Cost approach: values the business based on the cost to replace its assets. It’s often used for very early‑stage or asset‑heavy companies.
   
   

Valuation firms will ask for qualitative and quantitative data, revenue, net income, growth projections and industry risks to determine which approach best fits your company.

Who should perform the valuation?

While you could try doing your own valuation, the IRS only grants safe harbor if the appraisal is done by an independent third party. Valuation providers have experience applying the appropriate methods and documenting the process. They shoulder the heavy lifting so founders can focus on building the business. An external report also reassures employees and investors that the FMV is objective.

Tips to get ready

• Get your books in order. Accurate financials and projections make the appraisal smoother. Check out our posts on accrual accounting and preparing for your first audit.
  
  
• Keep your cap table up to date. A clean record of shareholders and option grants is essential for the backsolve method and K‑1s.
  
  
• Plan ahead. Schedule a valuation before major events to avoid delays in offering new options.
  
  
• Don’t lowball or highball. Undervaluing your stock can lead to penalties; overvaluing makes options less attractive.
  
  

FAQs

How long is a 409A valuation valid?
The IRS generally treats a valuation as reasonable for 12 months unless a material event occurs.

Do convertible notes or SAFEs require a 409A?
Yes. Even if you use convertible instruments, you still need a valuation before granting options to employees. A current valuation also helps you negotiate future rounds.

Can I do the valuation myself?
You can, but without an independent third party you won’t have safe harbor. Hiring a qualified firm reduces risk.

What happens if I don’t update after a new round?
Issuing options at an outdated FMV may be treated as granting options below FMV and trigger penalties.

Wrapping up 

A 409A valuation might sound intimidating, but it’s one of the most important tools to protect your team and stay compliant. By setting a fair strike price, you keep the IRS happy, build employee trust, and prepare for future rounds. Remember: you need a fresh valuation before your first option grant and whenever something big changes.