409A Valuations: A Complete Guide for Startups

Greg O'Brien CPA

Published December 21, 2024

Mistakes with 409A valuations are all too common in startups — but they don’t have to be. From errors in execution to the misconception that they’re unnecessary, these pitfalls can lead to severe tax penalties, unhappy employees, and wary investors.

In this article, you’ll learn exactly what 409A valuations are, why they’re crucial for your company’s future, and how they impact everything from employee compensation to investor negotiations.

What is a 409A valuation?

A 409A valuation is an IRS-approved assessment of a private company's common stock’s fair market value (FMV).

The purpose of this valuation is to ensure compliance with IRS regulations, particularly for deferred compensation arrangements like employee stock options and other equity awards.

For startups, this valuation is crucial since early-stage companies often have illiquid stock that can be difficult to accurately price. By obtaining a 409A valuation from an independent valuation provider, startups ensure that their stock value is defensible, avoiding potential penalties from the IRS. This is especially important ahead of major milestones or liquidity events, such as an IPO or acquisition, which can dramatically impact the value of the company.

How is a 409A valuation different from a strike price or VC valuation?

Although they may seem similar on the surface, a 409A valuation, strike price, and VC valuation are three different things that serve unique purposes.

A 409A valuation is a necessary third-party assessment of the fair market value (FMV) of your company's common stock. It’s primarily used to keep stock options or equity awards in line with IRS regulations.

The strike price, on the other hand, is the price at which employees, advisors, or other option holders can buy shares when they exercise their options. The strike price is set at or above the FMV calculated in your 409A valuation, which is why these terms are often confused.

A VC (Venture Capital) valuation is different from both a 409A valuation and the strike price. It reflects the value of your company as determined during a fundraising round based on negotiations between founders and venture capital investors. This valuation often emphasizes future growth potential, market opportunities, and investment terms, making it inherently forward-looking. Unlike a 409A valuation, which tends to produce a conservative estimate of your company's current value, a VC valuation is typically more optimistic and tied to market dynamics and investor sentiment.

Why do 409A valuations matter?

409A valuations are important for a variety of reasons, but here are three of the most important ways this valuation can affect your startup.

1. Tax law compliance

The primary reason for obtaining a 409A valuation is to comply with IRS regulations governing deferred compensation. Setting the exercise price of your company's stock options in line with or above the fair market value (FMV) determined by a 409A valuation helps shield your business from costly penalties and tax consequences — both now and in the future.

In the early stages, some founders may be tempted to assign a nominal value, such as “zero,” to their stock. While this may appear convenient at first, it can lead to significant income tax issues for your employees down the line.

Companies are also required to report the value of stock options and other equity awards in their financial statements in accordance with GAAP. Guessing your company’s value is not a viable option, as accurate valuations are needed for both tax compliance and regulatory disclosures.

2. Talent recruitment

Stock options are a critical part of many compensation packages, often serving as a major incentive for attracting top talent. In most startup industries, employees often expect to receive stock options as part of their deal. If they are an original employee of your startup, this could be a significant portion of their compensation package.

A professional and defensible 409A valuation ensures that these options are priced correctly, meaning there will be no unwanted surprises when employees exercise their options.  For example, a few years ago, we had a client come in who had set up their company and issued stock options at a fair market value of $.0001.  As this company began to raise money, its lead investor questioned this number. Upon further review, the FMV was revised upwards to nearly $1, which caused tax issues for the original employees.

Offering a defensible valuation not only protects your employees but also enhances your credibility with potential hires and investors. When your equity compensation is properly valued, you build trust and demonstrate that your company takes compliance seriously.

3. Fundraising efforts

While the primary purpose of a 409A valuation is to set the exercise price for stock options, it can also play a role in fundraising — albeit indirectly. Investors may view your 409A valuation as one of several indicators of your company's current worth, particularly during equity negotiations.

It’s important to remember, however, that a 409A valuation typically reflects a more conservative estimate of your company’s value compared to what you might see during a fundraising round. In most cases, the enterprise value established during fundraising will exceed your 409A value. This distinction matters as it ensures your stock options remain affordable for employees while reflecting realistic market expectations for your business during investor discussions.

How does a 409A valuation work?

A 409A valuation starts with hiring a qualified, independent third-party firm to assess your company’s FMV. Once you've picked a firm to partner with, they will go through the following steps:

1. Data Collection: The valuation firm gathers essential information about your company, such as financial statements, cap tables, historical growth data, industry trends, and any significant milestones (like fundraising rounds or acquisitions).
2. Methodology Selection: Valuation experts choose the right methodologies to evaluate your company. Common approaches include the market approach (based on comparable companies or transactions), the income approach (projected cash flows), and the asset-based approach (net asset value). The valuation method chosen will often come down to your company’s stage, market activity, and growth trajectory.
3. Valuation Analysis: Using the gathered data and selected methodologies, the valuation firm calculates your company's FMV. This step often involves detailed modeling and adjustments for factors like market volatility, recent investments, or major changes in your industry.
4. Report Creation: The firm compiles its findings into a formal report that outlines how it determined the FMV, including key assumptions, data used, and analysis methods. This report provides the documentation your company needs to comply with IRS regulations and withstand potential audits.
5. Final Review and Implementation: Once you receive the 409A valuation report, it’s important to review it thoroughly with your legal and tax advisors. Upon finalization, this valuation sets the exercise price for stock options, ensuring your equity awards are compliant and defensible.

How often should you update your 409A valuation?

It's generally recommended to update your 409A valuation at least once a year or after any significant events that could impact the company’s valuation, such as fundraising, major changes in revenue, or significant shifts in the market.

Regular updates ensure that your stock options are priced accurately and remain compliant with IRS guidelines.  Do you need to do this like clockwork on an annual basis?  No, but you should try to keep this as updated as possible.

While there is no all-encompassing list of significant events that should trigger a new valuation, here are the items we see most often in practice:

• Major secondary transactions where a third party buys stock from an existing shareholder at a notably different value compared to the stated FMV
• New equity or debt financing
• Market pricing corrections or differences
• World events that affect your industry

What are some common misconceptions about 409A valuations?

We hear all kinds of misconceptions about 409A valuations from our clients. Here are the most common ones.

409A valuations aren’t worth the cost

While there is a cost associated with 409A valuations, the potential expense of not having one can be much higher due to penalties and tax liabilities. Ignoring the need for a 409A valuation can also expose the company to legal risks if employees face unexpected tax issues.

We see many valuation firms offering discounted or attractive valuation prices for startups.  While you should ensure a fair price, do not always go with the cheapest option.

409A valuations are only needed when raising Series A or beyond

Companies should regularly update their valuations, especially after significant changes in business conditions. New valuations are needed at all significant events, which could include a small round or even a secondary stock sale.

Using the same firm for multiple 409A valuations is a bad idea

Using the same firm for multiple 409A valuations isn’t necessarily a bad idea. As long as you are satisfied with their work and they maintain their independence and objectivity, there’s no reason not to continue with them.

In fact, consistency can actually be beneficial because they'll have a deeper understanding of your business over time. Startups with unique ideas, products, or services may be best served to develop a long-lasting relationship so they do not need to re-explain and teach each new firm about their company.

Ensure compliance and maximize benefits with strategic 409A valuation planning

The 409A valuation process, while sometimes a pain, is a critical part of managing a startup. Regular updates and accurate valuations help prevent tax penalties, attract talent by correctly pricing stock options, and prepare your company for future growth opportunities.

When determining if it’s time for a 409A valuation, founders should consult with both their corporate counsel and tax advisors to make informed decisions. If you are looking for startup-friendly tax advice, please reach out to our team. We can help offer the specialized tax advice you need to ensure your startup is safely looked after come tax time.

409A valuation FAQs

What if the IRS challenges our 409A valuation?

If the IRS challenges your 409A valuation, they could determine that the exercise price of your stock options was set too low.

This finding could result in penalties and immediate income recognition for option holders, as well as interest charges. To mitigate this risk, it’s crucial to work with a reputable valuation firm and tax advisor who can provide a well-documented and defensible valuation.

Are employees penalized for non-compliant 409A valuations?

Yes, if the 409A valuation is not compliant, employees who hold stock options may face significant penalties.

These can include immediate taxation of the option’s value upon vesting, a 20% IRS penalty on the income recognized, and additional interest penalties. This alone should encourage startups to take this process seriously.