What Is a 409A Valuation?

What is a 409A valuation?

A 409A valuation is an independent appraisal that determines the Fair Market Value (FMV) of a private company’s common stock. The IRS requires this valuation to ensure that stock options and other forms of equity compensation are priced fairly and comply with tax regulations.

Once the FMV is established, it is used to set the strike price for employee stock options and comply with IRS rules. 

It protects companies with costly penalties by accurately pricing equity, based on the company’s current financial standing rather than inflated projections.

If the strike price is too low compared to the FMV, it can lead to significant tax liabilities for employees. On the other hand, if the strike price is set higher than the FMV, the options would become less attractive for employees.

Example:

Let’s say the company’s FMV is $10 per share.

1. Strike price below FMV:

If the strike price is $5, the IRS considers the $5 difference as ordinary income and taxes it at the time of the grant, even before the options are exercised.

2. Strike price equal to FMV:

If the strike price is $10, there are no immediate taxes.

3. Strike price above FMV:

If the strike price is set at $15, employees would need to pay $15 per share to purchase stock worth $10 per share on the open market.

409A valuation in India

You need a 409A valuation if your company has a US legal entity (for example, a Delaware holding company) or grants equity to US tax resident employees, advisors, or contractors. In that case, US tax rules apply to those grants, and the IRS expects you to price them based on an independent 409A valuation.

For purely Indian companies with only Indian-tax-resident employees, 409A is usually not required. Instead, Indian tax law applies, specifically the income tax act and the prescribed method for determining FMV for ESOPs.

But the moment you add a US entity or US taxpayers into the structure, a 409A valuation becomes relevant alongside your Indian FMV.

Why do startups need a 409A valuation?

A 409A valuation is needed for two main reasons:

1. Employee stock option pricing

When companies issue stock options, they must establish the fair market value (FMV) of their common stock to set the exercise price. The FMV serves as the benchmark to ensure the stock options are priced correctly and in compliance with IRS regulations.

2. IRS penalty avoidance

For private companies, IRC Section 409A regulates the pricing of stock options and other equity-based compensation. It mandates that stock options be issued with a strike price equal to or greater than the fair market value (FMV) at the time of issuance.

Non-compliance with IRC Section 409A can lead to significant penalties, including immediate income tax on unvested options, a 20% penalty tax on deferred income, and interest charges.

A proper 409A valuation helps protect companies from these risks, ensuring their stock options are both compliant and attractive to employees.

What is IRC Section 409A?

IRC Section 409A is part of the U.S. tax code that governs non-qualified deferred compensation plans. It also applies to certain types of equity compensation, including Non-Qualified Stock Options (NSOs), if they are granted below FMV or include deferral features.

It ensures that employees don’t pay taxes on compensation they haven’t yet received. This applies to unvested stock options, provided the compensation complies with the regulations.

A non-qualified deferred compensation plan (NQDC) allows employees to delay receiving part of their income, such as salary or bonuses, until a later date, usually after retirement or when they leave the company. These plans are called "non-qualified" because they don't meet the specific requirements of tax-advantaged retirement plans like 401(k)s or pensions.

For companies, IRC Section 409A is crucial because it:

• Establishes strict rules for how companies must value their equity and structure their compensation plans.
• Protects employees from premature taxation. Without compliance, the IRS can require taxes on this compensation, even if the employee hasn’t yet gained access to it.
• Acts as the legal foundation for 409A valuation.

What is a 409A safe harbor?

A 409A safe harbor is a protection under IRC Section 409A that helps ensure a company’s stock option valuations are considered compliant with IRS rules. If a company follows specific IRS-approved valuation methods, the valuation is presumed reasonable, and the IRS is less likely to challenge it. This reduces the risk of penalties for both the company and its employees.

How does safe harbor work?

To qualify for safe harbor, a company must use one of the following IRS-approved valuation methods:

1. Independent appraisal method

Hiring an experienced third-party firm to perform a professional 409A valuation. The valuation must use generally accepted methodologies, such as Discounted Cash Flow (DCF), market comparables, or asset-based approaches.

2. Illiquid startup method

This method applies to private companies that do not have plans for an immediate IPO or public offering. The company determines its fair market value (FMV) by evaluating various factors, including its financial performance, potential risks, and recent funding rounds. 

This method takes into account the fact that the company’s stock is not easily tradable on public markets, making it harder to determine its value.

3. Binding formula method

In this approach, a predetermined formula is used to calculate the fair market value of a company's stock. This method is uncommon and is typically used in specific situations like buy-sell agreements, where there is an agreement between shareholders about how the stock’s value will be determined under certain conditions

By using one of these methods, a company’s valuation is presumed valid under the safe harbor rule, making it harder for the IRS to dispute.

409A penalties: What happens if you don’t comply

Failing to comply with IRC Section 409A can lead to serious financial consequences for both employees and the company.

‍1. Immediate taxation on deferred compensation

If the 409A valuation is not compliant:

- All deferred compensation (e.g., unexercised stock options) becomes immediately taxable, even if the employee hasn’t received the funds or exercised the options.

- The IRS applies taxes retroactively to the year the options were granted and adds penalties and interest for the delayed payment.

2. Additional 20% federal tax

Employees are hit with an additional 20% federal penalty tax on the value of the deferred compensation. This is separate from regular income taxes.

When to get a 409A valuation?

You’ll typically need a 409A valuation at three points in your company’s journey.

1. Before granting stock options

If you plan to grant stock options to any U.S. tax-resident employee, advisor, or contractor, you should obtain a 409A valuation before the grant date. This ensures the strike price complies with IRS rules and establishes a fair, defensible FMV.

2. After a material event (409A refresh)

A material event is any change that could reasonably affect your company’s valuation. When this happens, your existing 409A may no longer be valid for issuing new option grants.

What qualifies as a 409A material event?

• A new equity funding round
• Receiving a credible acquisition term sheet
• Hitting or missing major revenue or product milestones
• A significant change in your business model, unit economics, or market outlook
• Large secondary transactions involving common or preferred shares

3. Every 12 months

Even without a material event, a 409A valuation is considered valid for a maximum of 12 months. To keep issuing options at a compliant strike price, most companies refresh their 409A annually.

How long is a 409A valuation valid?

A 409A valuation is generally valid for:

• 12 months from the effective date, or
• Until a material event happens, whichever comes first.

If you raise a new round, sign a major term sheet, or your business changes significantly, you’ll likely need a 409A refresh even if the last one is only a few months old.

How is a 409A valuation calculated?

When performing a 409A valuation, the valuation provider applies established methods to calculate the fair market value (FMV) of a private company’s common stock. The chosen method depends on the company’s stage, financials, and specific circumstances.

Here are the most common methodologies used:

1. Market approach

The market approach determines a company’s value by comparing it to similar businesses or transactions in the market. It's especially useful for startups or companies with limited financial history.

a. Guideline public company method: This method compares the company to publicly traded companies in the same industry, adjusting for differences in size, growth, and risk.

b. Guideline transaction method: This method looks at recent acquisitions or funding transactions of similar companies to estimate value.

2. Income approach

The income approach values a company based on its ability to generate future cash flows (DCF). It is generally used for more mature companies with established revenue streams.

3. Asset-based approach

The asset-based approach values a company by determining the net value of its assets, minus its liabilities.

In some cases, a 409A valuation provider may use a combination of these approaches to account for multiple factors, such as market conditions, company performance, and industry trends.

The 409A valuation process: Step by step

Getting a 409A valuation can feel intimidating the first time, but with a good provider the process is fairly structured and predictable. While the details vary, most 409A valuations follow a similar set of stages.

1. Kick-off and scoping

You start by choosing a valuation provider and agreeing on scope, timelines, and deliverables.

At this stage, you’ll typically share the basics: your company overview, current cap table, recent funding history, and high-level financials or projections. The goal is to give the analyst enough context to frame the engagement properly before they dive into the details.

2. Data collection and review

Next, the provider will request and review the core documents they need to value the company. This usually includes incorporation documents, your latest cap table, historical financials, projections, key contracts, and any recent term sheets or investor updates.

As they go through these materials, they may come back with clarifying questions or ask for additional data.

3. Business and risk discussion

Most providers will then schedule a working session or call with you and/or your leadership team.

This is where you walk the analyst through your business model, traction, market, competitive landscape, roadmap, and key risks. The qualitative story matters: it helps the analyst understand why your numbers look the way they do and how to think about the company’s future.

4. Valuation modelling

Once the analyst has enough context and data, they’ll build the actual valuation model. Depending on your stage and business, they may use market approaches (comparable companies or transactions), income approaches (discounted cash flow), or other accepted methods.

From there, they allocate the total equity value across different share classes (preferred vs. common) using an appropriate allocation method and arrive at an FMV per common share for 409A purposes.

5. Draft report and company review

When modelling is complete, the provider prepares a draft 409A report.

You review this draft to confirm that it accurately reflects your company’s facts: cap table, financing history, business description, and key assumptions. This review is not about negotiating the number up or down, but about making sure the underlying information is correct and that nothing material has been misunderstood or missed.

6. Final report and board approval

After you sign off on the draft, the provider issues the final 409A valuation report.

How to choose a 409A valuation provider

Picking a 409A provider is less about hunting for the absolute lowest fee and more about finding a partner you’re comfortable defending in front of an auditor or acquirer.

Here’s what to look for.

1. Independence and qualifications

For safe harbor, your provider must be a qualified, independent third party. In practice, that means:

• They don’t have a stake in your company
• They regularly do private company valuations (not just generic consulting)
• Their analysts have relevant backgrounds (valuation, investment banking, audit, corporate finance)

2. Experience with your stage and business model

A seed-stage SaaS startup and a late-stage fintech with multiple entities don’t look the same to an appraiser.

Look for a provider that:

• Has valued companies at your stage (pre-revenue, post-revenue, late stage, etc.)
• Understands your business model (SaaS, marketplace, D2C, deep tech, etc.)
• Is familiar with your typical investor set and deal terms

3. Methodology and transparency

You don’t need to love spreadsheets, but you do need a provider that can explain their logic in plain English.

Look for:

• Use of accepted methods (market, income, asset approach, OPM backsolve)
• Clear documentation of assumptions (discount rates, comparables, growth rates)
• A willingness to walk you through the report and answer questions

4. Audit defensibility and support

The real value of a 409A provider shows up years later when due diligence or an audit happens.

Check whether the provider:

• Has experience
• Will stand behind the valuation in case of questions from auditors, investors, or the IRS
• Offers support if you get follow-up questions in a later funding or exit process

5. Turnaround time and process

In practice, you often realise you need a 409A when you’re about to grant options. Delays can stall hiring or offer letters.

Compare providers on:

• Typical turnaround time (for example, 1–2 weeks vs 3–4 weeks)
• How structured their data collection is (checklists, templates, integrations)
• Whether they allow expedited timelines when needed (and at what cost)

6. Integration with your cap table and workflows

If your 409A provider also manages your cap table and ESOP (e.g., EquityList), you enjoy few benefits:

• Less manual work (no copy–pasting cap tables into spreadsheets)
• Lower risk of using stale or inconsistent data
• Easier refreshes, since your equity records stay in sync

7. Pricing and value

409A pricing can range from under $1,000 for simple early-stage companies to several thousand dollars for complex structures.

Instead of just chasing the lowest quote, look at:

• What’s included in the fee (initial call, draft review, support, refreshes)
• Whether you get discounted or included valuations as part of a cap table / ESOP platform
• How often you’re likely to need refreshes based on your fundraising cadence

How much does a 409A valuation cost?

The cost of a 409A valuation depends on your company’s stage, cap table complexity, and the provider you choose. For a standalone 409A report, valuers typically charge anywhere from $1,000 to over $10,000, depending on how complex your financials and capital structure are.

Platforms that bundle 409A valuations with cap table software follow a different model. Instead of paying for each individual report, valuations are included as part of your subscription (depending on which plan you are on), which makes compliance more predictable and operationally simpler.

EquityList supports both models:

• Standalone valuations for companies that only need a one-off 409A report
• Subscription-based valuations included for customers using EquityList for cap table and ESOP management

Get your 409A valuation through EquityList today.

409A valuation vs VC valuation vs FMV vs strike price

Founders often use these terms interchangeably, but each serves a very different purpose in a company’s equity and tax framework.

409A valuation vs VC (pre-money / post-money) valuation

A VC valuation is a negotiated number that comes out of a fundraising round. It reflects what investors are willing to pay for preferred shares, which come with rights like liquidation preferences, anti-dilution protections, information rights, and governance privileges. Because these preferred shares carry additional economic and control rights, the VC valuation ends up representing the value of a security that is fundamentally different from what employees receive.

A 409A valuation, on the other hand, is an independent, third-party appraisal done strictly for tax compliance. Instead of valuing preferred shares, it determines the fair market value of common stock — the shares employees receive through stock options.

Since common shares have no special rights and sit last in the liquidation stack, a 409A valuation applies discounts for illiquidity, risk, and lower priority. This is why the 409A FMV per common share is almost always lower than the price investors pay in your latest funding round.

409A valuation vs FMV

A 409A valuation is both the process of valuing a company’s stock and the report that documents it. The result of this process is the FMV, which is the price per common share that the IRS considers justifiable. So when teams say “our 409A is $10,” they are actually referring to the FMV determined in the most recent 409A valuation.

409A valuation vs strike price

The 409A valuation sets the FMV per common share on a particular date. The strike price is what an employee must pay when exercising their stock options. For US tax compliance, the strike price of any new option grant must be at least equal to the FMV established by a valid 409A valuation.

Put simply: the 409A sets the minimum price at which options can legally be granted, and the strike price is the amount employees will eventually pay if they choose to exercise those options.

FAQs

What is a 409A valuation used for?

A 409A valuation is used to determine the IRS-defensible FMV of your company’s common stock so you can grant employee stock options at a compliant strike price. Companies rely on this valuation to protect employees from tax penalties, maintain safe-harbor compliance, and support ASC 718 accounting.

Why do you want a low 409A valuation?

A defensible, lower 409A valuation leads to a lower strike price, making employee stock options more attractive. When employees can buy shares at a lower cost, their potential upside increases, which helps startups stay competitive in hiring and retention.

However, the valuation must still be reasonable and supported by accepted methodologies. If a company intentionally understates its valuation, the IRS can treat the options as discounted compensation, which can trigger immediate income tax, a 20% penalty, and interest for employees.

How long does a 409A valuation take?

A 409A valuation typically takes 1 to 3 weeks from the time you submit your documents. The exact timeline depends on your company’s stage and how complex your cap table or financial model is.