How 409A Price Impacts Your Startup’s Stock Options

Attracting and retaining top talent makes all the difference when it comes to succeeding as a startup. As your company grows and expands, you may find it useful to offer equity compensation in the form of stock options to recruit the best talent in your field.

However, before you think about granting any stock options, you’ll need to determine the fair market value of your common stock per Section 409A of the IRC. This process is known as a 409A valuation, and we’ll explore how it works in more detail for this article.

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Table of contents
What is a 409A Valuation? Calculate How Much Your Business Could Save on Cross-Currency Transfers Understanding Safe Harbor Status 409A Valuation vs Fair Market Value How is 409A Calculated? 409A Valuation Requirements Which 409A Valuation Methodology is Best? How long is a 409A valuation good for? Do I need to determine my company’s 409A price?

What is a 409A Valuation?

A 409A valuation is an independent appraisal of a private company’s fair market value for its common stock. Simply put, it’s one of the main ways to value a private company.

If you’re running a private company such as a startup, you may need a 409A valuation in the following scenarios:
Before issuing common stock options: It’s considered best practice to perform a valuation before granting any stock options, even amongst first hires and advisors.
Before an IPO, merger, or acquisition: Liquidity events allow shareholders to convert their equity into cash, so you’ll need to update your valuation accordingly.
After a material event: Any event that could impact a company’s stock price, like a financing round or acquisition, will require a new 409A valuation.

This process is named after Section 409A of the U.S. tax code—one of the main frameworks private companies are required to follow when valuing their stock.

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Understanding Safe Harbor Status

When the 409A valuation is presumed to be reasonable by the IRS, companies receive “safe harbor” status—meaning that they’re protected against the severe tax penalties associated with non-compliance.

Those tax penalties come at a high cost. Companies that fail to adhere to 409A regulations can face immediate taxation on all deferred compensation from the current and preceding years. Plus, the IRS can impose an additional 20% tax on that deferred compensation, and then charge accrued interest on the revised taxable amount. ¹

Needless to say, you’ll want to do everything in your power to shield your employees and shareholders from these consequences. That’s where safe harbor status comes into play.

The IRS awards this distinction to companies whose 409A price can be presumed to be reasonable. There are three methods available to reach this status.

The most common is known as Independent Appraisal Presumption. This is when an organization works with a qualified third-party appraiser to receive a valuation. The appraiser will use one of the standard valuation methods—market, income or asset-based approaches—to secure “safe harbor” status with the IRS.

Depending on the startup’s status, it might not have the cash on hand to hire a qualified third-party appraiser. In those instances, leaders may consider one of the other preparation methods, such as the Binding Formula Presumption. With this approach, a formula is used to determine the company’s fair market value.

While this approach may seem easier and more cost-effective, it’s important to recognize the risks you take when you choose to use a formula. You’ll need to make sure you apply that formula systematically across all equity transactions—otherwise, you risk invalidating your presumption. As we’ve seen in the earlier section, that comes at a high cost to you and your employees in the form of regulatory penalties and fines.

Early-stage companies who don’t have the resources on hand to hire an independent valuation expert might choose the Illiquid Startup Presumption instead. This approach is available only to early-stage companies who meet specific criteria. If a company qualifies, it can opt to have an experienced individual—usually a company insider with relevant expertise—determine the fair market value using available financial data.

Startups tend to choose to work with a reputable and independent provider to ensure they reach safe harbor status. ²

Of course, you’ll want to do your due diligence on the provider before choosing to move forward with them. Take all the necessary steps to ensure they have the qualifications and expertise needed so you don’t face those costly tax penalties.

409A Valuation vs Fair Market Value

Understanding 409A valuation requires distinguishing it from fair market value. While closely related, these concepts differ significantly in their intended descriptions.

A 409A valuation is a specific method to determine a private company’s fair market value. It’s performed annually, in most cases, using specific methodologies accepted by the IRS to maintain compliance with the U.S. tax code.

Meanwhile, fair market value is a much broader concept. It represents the amount interested parties are willing to pay for a certain asset in an open market. It can apply to various scenarios—not just when dealing with a company’s stock. Fair market value can be determined through many different methodologies depending on the context and asset type.

How is 409A Calculated?

While a 409A valuation may seem like a complex undertaking for a smaller team, ultimately, it’s an important step toward establishing a fair and attractive compensation package for your employees.

Even in the early stages of your startup’s growth, a 409A valuation is a great way to get started with a compensation program designed to reward the people who’ve worked hard to make your startup a success. Even better, this process demonstrates your overall commitment to proper financial management.

If you’re looking to move forward with the process, it can be helpful to understand what independent valuation providers will expect you to provide to deliver a comprehensive valuation of your company.

409A Valuation Requirements

To start, let’s take a look at the information you’ll need to have on hand to conduct a 409A valuation in the first place.

If you’re working with an independent appraiser, you’ll need to be able to provide detailed information about your company and its financials. You can start by gathering key information about your company, such as the CEO, auditors, legal counsel, and articles of incorporation.

It’s also useful to have information about your industry available, including a list of comparable public companies. Depending on the methodology used, this information may be used to determine your startup’s fair market value.

From there, gather your historical financial statements and prepare to discuss key financial performance indicators such as revenue and EBITDA forecasts, cash burn rate, and debt amount. If you’re unsure of the financial plans you need to have in place and the key metrics you need to track, check out our guide to creating a financial plan for a startup business before you bring in your appraisal expert.

With all of these key documents available, you can finish by sharing any information you have on hand about material events that have taken place since the last valuation, as well as any liquidity events on the horizon. These will also shape the valuation as well as the methodology used to calculate the fair market value.

Which 409A Valuation Methodology is Best?

When it comes time to start your 409A valuation, your appraiser will likely choose between one of the leading calculation methods based on your startup’s financial situation and its current stage of development.

Asset Approach, also known as Cost Approach, is the most common choice for early-stage companies without revenue or financing. This method calculates the company’s net asset value to determine the valuation.

1. To start, identify all tangible and intangible assets.
2. Determine the fair market value of each asset.
3. Subtract liabilities from the total asset value.

The resulting net asset value becomes the company’s valuation.

Since the Asset Approach doesn’t account for future growth potential, it’s really only suitable for pre-revenue startups. However, if the business has sufficient revenue and positive cash flow, the appraiser will likely choose to take the Income Approach instead.

With this method, estimate the company’s value based on projected future cash flows, adjusting accordingly for risk factors.

1. First, project future cash flows over a specific period, usually around five or more years.
2. Apply a discount rate to account for risk and time value of money.
3. Calculate the present value of these future cash flows.

The approach isn’t straightforward as it requires careful assumptions about growth rates, profit margins, and risk factors. The final valuation is significantly impacted by the accuracy of the projections.

If your company has just gone through a financing round, you’ll likely use the Market Approach or Option Pricing Model (OPM) Backsolve instead. This method uses the option pricing model to “backsolve” and determine the fair market value or common stock.

1. Using the recent preferred stock transaction as a starting point.
2. Apply the Option Pricing Model to backsolve the value of the common stock.
3. Adjust for differences between preferred and common stock rights, considering that investors usually receive preferred stock.

For leaders running a more unique startup, the market approach can be challenging, since it relies on comparable transactions to make its calculations. Appraisers may combine it with other methods to give a more comprehensive understanding of a company’s valuation.

How long is a 409A valuation good for?

409A valuations are valid for a maximum of 12 months from the effective date.

The exception to updating a 409A valuation within 12 months is a material event—any occurrence that could impact the company’s stock price. In such an event, a new valuation is required.

Common examples of material events include financing rounds, acquisitions, strategic partnerships, or regulatory changes.

If you're unsure whether your 409A valuation needs an update, consult an experienced provider or lawyer to avoid costly tax penalties.

Do I need to determine my company’s 409A price?

Ultimately, if you’re planning to offer equity or stock options to your employees, you will likely need to determine your company’s 409A price.

This independent appraisal process isn’t just an IRS requirement— it ensures tax compliance, protecting both your company and employees from costly fines and penalties. Even better, it demonstrates your company’s financial diligence, strengthening your credibility with both current and future investors.

To stay compliant with the U.S. tax code, be sure to obtain a 409A valuation before issuing common stock options. You’ll also need to update this valuation on an annual basis or after any material event that could impact your company’s value.

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Sources

1. 3 Hidden Risks of 409A Non-Compliance
2. 409A Valuation