A founder’s guide to the 409A valuation

What is a 409A valuation?

A 409A valuation is an independent appraisal of the fair market value (FMV) of a private company’s common stock. Its main purpose is to determine the minimum strike price for stock options, which is the price your employees will pay to purchase their shares.

If your company plans to issue equity to employees, advisors, or other service providers, you’ll generally need a 409A valuation to remain in compliance with Section 409A of the U.S. Internal Revenue Code (IRC). Section 409A was enacted in 2005 to ensure that equity-based compensation is appropriately valued and taxed, and companies that fail to obtain an independent 409A valuation risk triggering significant tax penalties.

Beyond preventing IRS penalties, having an audit-defensible 409A valuation can also help startups attract and retain talent with competitive equity compensation, build credibility with investors during fundraising, and streamline the due diligence process during a merger or acquisition.

Think of it this way: when you grant stock options, you're giving your team the right to buy a piece of the company in the future. The 409A valuation sets the fair market value of the shares at the time the stock options are granted, which is the minimum price for that purchase. Get this right to protect your employees from unexpected tax penalties.

Why your startup needs a 409A valuation

As a founder, you know that equity is one of your most powerful tools for attracting and retaining top talent. Even when market downturns make stock options less attractive, companies work to restore their value. In 2023 alone, 873 companies on Carta undertook the complex process of repricing nearly 100,000 option grants so that they remained a compelling incentive for employees.

If you plan to offer stock options to your team from an employee option pool, getting a 409A valuation is a required first step. It allows you to confidently issue stock options to service providers and protects your company and your employees from IRS penalties.

Beyond hiring, a 409A valuation is a mark of professionalism that builds trust with investors. A history of regular, defensible valuations shows that you are organized and take compliance seriously. This can streamline due diligence during fundraising rounds and make your company a more attractive investment.

When to get a 409A valuation

Knowing when to get a 409A valuation helps you stay compliant and prepared for growth. You should plan to get a valuation at several key moments in your company’s journey.

If you intend to offer equity to U.S. tax residents, it is best practice to obtain an independent 409A valuation before issuing your first common stock options. Early-stage companies and founders also need 409A valuations to protect shareholders from certain tax penalties. Working with a reputable, independent 409A valuation provider helps ensure safe harbor status with the IRS.

Here’s when you will need a 409A valuation:

• Before you issue your first stock options to employees or advisors.

• After a material event occurs that could change your company’s value.

• At least once every 12 months to maintain compliance and continue issuing options.

What qualifies as a 409A material event?

A material event is any significant business change that could reasonably affect your company's stock price. It’s a signal that your company's value has likely changed, making your previous 409A valuation outdated.

Common examples of material events include:

• You close a new financing round, whether it's a priced round, SAFE, or other convertible securities like a convertible note.

• You receive a credible term sheet offer to be acquired by another company.

• Your financial projections change in a big way, either for the better or for the worse.

• You enter a strategic partnership that opens up a new market or dramatically changes your business model.

If you aren’t sure whether a recent event is considered material, reach out to a 409A valuation provider or consult your lawyer.

How long is a 409A valuation valid?

A 409A valuation is valid for a maximum of 12 months from its effective date. However, its validity ends sooner if a material event happens. Whichever comes first, that's when you'll need to get an updated valuation.

This updated appraisal is often called a “409A refresh.” As your company grows and evolves, getting regular refreshes becomes a normal part of your operational rhythm, ensuring your option grants are always compliant with tax law and other regulations.

Understanding IRC Section 409A and its penalties

Internal Revenue Code (IRC) Section 409A is the part of the U.S. tax code that sets the rules for stock options and other forms of deferred compensation, which are typically issued under an exemption like Rule 701. Its goal is to prevent companies from issuing stock options at an artificially low price, which could be seen as a way to avoid taxes on short-term and long-term capital gains.

The IRS introduced Section 409A in 2005 in response to the 2001 Enron scandal, as regulators were looking for ways to prevent executives from taking advantage of equity loopholes. A final version went into effect in 2009.

The consequences of non-compliance fall heavily on your employees. If the IRS determines your strike price was too low, your team members could face immediate income taxes on their vested options, plus an additional federal penalty, interest, and potentially alternative minimum tax (AMT). This can turn a valuable incentive (which could otherwise be eligible for benefits like qualified small business stock (QSBS) tax treatment) into a financial burden, which is the last thing you want for your team.

What is 409A safe harbor?

An independent 409A valuation establishes a “safe harbor” status with the IRS, which provides a presumption of reasonableness for the valuation and protects companies from penalties related to stock option pricing—as long as the valuation is valid, follows acceptable methods, and is deemed “reasonable” and audit-defensible. Think of safe harbor as a shield that protects your company and your employees from IRS penalties.

The IRS provides three safe harbor methods for setting the FMV of private company’s common stock:

1. Independent appraisal presumption: This is the most common way to obtain safe harbor status and means you have an independent valuation from a qualified, third-party appraiser.

2. Binding formula presumption

3. Illiquid startup presumption

When you have a safe harbor valuation, the burden of proof shifts. Instead of you having to prove your valuation is correct, the IRS has to prove it is "grossly unreasonable," which underscores the importance of proper tax filings like Form 3921 for any exercised ISO. This provides significant peace of mind and is the standard practice for startups that issue equity.

409A penalties

When your 409A valuation isn’t performed using one of the IRS-approved methods, it could fall outside of the 409A safe harbor. The penalties can be substantial for employees and shareholders:

• All deferred compensation from the current and preceding years becomes taxable immediately

• Accrued interest on the revised taxable amount

• An additional tax of 20 percent on all deferred compensation

Most startups aren’t likely to be audited by the IRS. However, as your company grows and you approach an exit (like a merger, acquisition, or IPO), it’s possible you could face IRS audits. You’ll save time and effort by working with a reputable valuation provider from the beginning.

How is a 409A valuation calculated?

There are three standard methodologies providers use during a 409A: market approach, income approach, and asset approach. Appraisers consider factors such as a company’s current assets, its cash flows, comparable public companies, and the implied valuation from any recent secondary transactions. The method they choose depends on your company's stage, industry, and financial health.

1. Market approach (OPM backsolve)

When your company raises a financing round, valuation providers typically use the option pricing model (OPM) backsolve method. It can be safely assumed that new investors paid FMV for the equity, but investors typically receive preferred stock instead of common stock. This method makes adjustments to determine the FMV for common stock.

Other market-based approaches use financial information like revenue, net income, and EBITDA (earnings before interest, taxes, depreciation, and amortization) from comparable publicly traded companies to estimate the company’s equity value.

2. Income approach

For businesses with sufficient revenue and positive cash flow, valuation providers often use the straightforward income approach. This method defines the value of the company based on its expected future cash flows, adjusted for risk. An appraiser will forecast your future cash flows and then discount them back to a present value. This is better suited for more mature companies with a predictable revenue stream.

3. Asset approach (cost approach)

This method calculates your company's value based on the FMV of its net assets. It's often used for very early-stage companies that have not yet raised money or generated revenue.

The 409A valuation process

Getting a 409A valuation might sound intimidating, but it's a straightforward process when you work with the right provider. It generally involves three main steps.

1. Gather your documents: You'll need to provide key company documents, such as your articles of incorporation, your cap table, and your financial statements or projections, which should follow ASC 718 guidelines for expensing stock options. If your cap table is managed on Carta, it's always up-to-date and ready to go, which greatly simplifies this step.

2. Kick off with your provider: This is typically a call where you'll discuss your business with the valuation analyst. You'll share the story of your company, recent progress, and your plans for the future, giving the analyst the context they need to perform the valuation.

3. Review the draft report: Before the valuation is finalized, you'll receive a draft 409A valuation report. This is your opportunity to review it for factual accuracy and ensure the analyst has correctly understood your business.

After you've provided your documents and kicked off the project, your provider will deliver a draft report for your review. To help you understand what a comprehensive, audit-defensible report looks like, you can download the sample report to see a complete example.

409A valuation example

To see what a complete 409A valuation report should look like, download a sample 409A report below:

Free 409A valuation report example

See what a complete 409A valuation looks like with this free example 409A report.

Download the report

How to choose a 409A provider

Choosing a provider of 409A valuation services is about finding a long-term partner who understands the startup journey. You want a firm that can provide an accurate, defensible valuation while making the process as smooth as possible.

To meet the IRS’s requirements, a valuation provider should:

• Be a qualified, independent third-party appraiser with at least five years of relevant experience in business valuations or appraisals, financial accounting, investment banking, private equity, secured lending, or other comparable experience

• Have recent experience valuing similar private companies

• Use generally accepted valuation methods such as market approach, income approach, or asset approach

• Provide a detailed and comprehensive report

• Comply with IRS Section 409A guidelines

Here are a few additional things to look for:

• Experience and reputation: Look for a provider that is trusted by major audit firms and has valued thousands of companies at your stage and in your industry.

• Integrated platform: A provider that also offers cap table management can save you time and reduce the risk of errors. When your valuation is connected to your cap table, data flows seamlessly, eliminating manual work.

• Audit defensibility: Your provider should stand by their report. Confirm that they will support you if the IRS or an auditor ever questions your valuation.

How much does a 409A valuation cost?

The cost of a 409A valuation can vary. Traditional valuation firms often charge a significant one-time fee for a standalone report, which can be a burden for early-stage startups managing a tight budget. For standalone valuations, the cost ranges anywhere from $1,000 to over $10,000, depending on the size and complexity of your company.

Some platforms, like Carta, take a different approach. With Carta for cap table management, 409A valuations are included in your subscription. This model makes compliance a predictable and manageable part of your operating budget.

409A valuation vs. fundraising valuation

One of the most common points of confusion for founders is the difference between a 409A valuation and a fundraising valuation. While both put a price on your company, they serve very different purposes and almost always result in different numbers.

A fundraising valuation is what investors use to determine the price they'll pay for preferred stock, while a 409A valuation determines the FMV of your common stock for tax purposes.

→ Learn more about pre-money vs. post-money valuations

Common 409A myths and mistakes

Equity is full of old rules of thumb that can lead founders astray. Understanding the common myths about 409A valuations can help you avoid costly mistakes.

Myth: The lower the strike price, the better.
Reality: An artificially low strike price is a major red flag for auditors and the IRS. The goal is to set the lowest defensible price to protect your employees from tax penalties while still making the options an attractive incentive.

Myth: My 409A value should just be a fraction of my last round's price.
Reality: While your fundraising valuation is an important input, a 409A is a complex appraisal to determine the fair value of common stock, not a simple percentage. Relying on outdated formulas can lead to non-compliance and put your team at risk.

How Carta simplifies 409A valuations

Getting a 409A valuation shouldn't be a source of stress. At Carta, we've integrated valuations directly into our equity management platform to make the process simple, accurate, and professional.

• A single source of truth: Your valuation is connected directly to your cap table on Carta. This ensures accuracy and saves you from the headache of chasing down spreadsheets and manually entering data.

• Expertise you can trust: Our in-house team of experienced valuation analysts delivers thousands of audit-defensible 409A valuations every year. We understand the nuances of startups and have the expertise to support you.

• A platform that grows with you: From your very first 409A to preparing for an exit, Carta's platform scales with your company.

Carta is the country’s leading cap table management and 409A valuation provider, trusted with over 15,000 audit-defensible 409A valuations each year. We use best-in-class software and industry expertise to deliver valuations faster and for less than traditional providers.

We make complex compliance feel simple at every stage of your journey. To see how our platform can streamline your next valuation, request a demo.

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Frequently asked questions about 409A valuations

Is a lower 409A valuation always better?

No, an accurate and defensible valuation is always better. An artificially low valuation can expose your employees to significant tax penalties, which defeats the purpose of offering equity in the first place.

Can I do my own 409A valuation?

To get safe harbor protection from the IRS, your valuation must be performed by a qualified, independent appraiser. For this reason, doing it yourself is not recommended and will not provide the legal protection you and your team need.

What happens if my 409A valuation is too high or too low?

A valuation that is too low can trigger tax penalties for your employees. A valuation that is too high can make your equity grants less attractive to new hires, as the cost to purchase the shares may seem too expensive.

What financial and company information do I need to provide for a 409A valuation?

For a 409A valuation, you’ll need to provide your cap table, financial statements, financial projections, fundraising documents, corporate charter, details of outstanding debt, and any relevant board approvals or consents.

When should my company get its first 409A valuation?

Your company should get its first 409A valuation before issuing stock options to employees or other service providers for the first time.

How long does a 409A valuation take?

A 409A valuation typically takes one to three weeks, depending on your company’s complexity and how quickly you provide the required information.

How does a changing 409A valuation affect the strike price?

A changing 409A valuation directly affects the strike price, also known as the exercise price, as new option grants must be priced at or above the updated FMV determined by the most recent 409A valuation.

What should I do upon receiving my 409A valuation?

Upon receiving your 409A valuation, review the report for accuracy, have your board approve the new FMV, and use it to set the strike price for new option grants.

How can a company ensure it receives a supportable 409A valuation report?

A company can ensure it receives a supportable 409A valuation report by choosing an experienced, reputable third-party valuations provider, supplying complete and accurate information, and thoroughly reviewing the report for errors or inconsistencies.

What role does the 409A valuation play in option pool strategy for mature startups?

The 409A valuation sets the FMV for option grants, so for mature startups, it directly influences the cost and attractiveness of stock options when expanding or refreshing the option pool.

What should a global late-stage startup issuing stock options consider for 409A compliance?

A global late-stage startup should ensure its 409A valuation accurately reflects its complex capital structure and international operations, and confirm that stock option grants comply with both US and relevant local regulations.

How soon after a funding round should a company refresh its 409A valuation?

A company should refresh its 409A valuation as soon as possible after a funding round, typically within a few weeks, to ensure new option grants can be issued under an updated FMV.

Why are 409A valuations important when issuing stock options to early employees?

Setting an accurate FMV lets your first employees receive stock options at the lowest possible strike price, maximizing their potential upside while ensuring tax compliance and reducing legal risk for both the company and the employees.

How does a 409A valuation work for a company that’s still pre-revenue?

For a pre-revenue company, a 409A valuation is based on factors like recent funding rounds, business plan, market potential, intellectual property, and comparable companies instead of revenue. The firm uses methods such as the backsolve or option pricing model to determine FMV for stock options.

How should founders explain a lower 409A FMV to employees or investors?

Founders can explain a lower FMV compared to the last 409A valuation by noting that 409A valuations are based on a specific point in time and can reflect changes in market conditions, company performance, or other liabilities and risk factors. A lower FMV doesn’t necessarily mean the company is underperforming. It may simply result from updated company financials, broader market downturns, or increased uncertainty, all of which valuation firms consider to determine a fair and compliant strike price for new options.

Do I need to include safe notes or priced round details when getting a 409A valuation?

Yes, you need to include details of SAFE notes and any priced rounds when getting a 409A valuation, as they directly impact your company’s capital structure and are important factors in determining FMV.

Which software can help generate a compliant 409A report?

Carta can help generate a compliant 409A valuation report by streamlining data collection, leveraging expert valuation teams, and ensuring reports meet IRS regulations and standards.

What happens if an employee is issued options below FMV?

If an employee is issued stock options at below FMV, they could face significant tax consequences under IRS Section 409A, and the company may also be exposed to compliance risks.