Regulation, Tax And Filings · Intermediate · 7 minute read · No ads
409A Valuation
Also called Section 409A valuation, common stock fair market value
A 409A valuation is an appraisal of the fair market value of a private company’s common stock, used to set the exercise price of employee stock options. Granting at or above that value generally keeps the option outside Section 409A. The value goes stale after 12 months or a material event.
Key takeaways
- A 409A valuation estimates the fair market value of common stock. It is not the headline valuation from a preferred stock funding round, which is usually higher.
- An option granted at or above fair market value, with no extra deferral feature, is generally outside Section 409A.
- Getting it wrong can land on the employee: the spread may be taxed as income, plus an additional 20 percent federal tax and premium interest.
- Three safe harbor approaches can earn a rebuttable presumption of reasonableness. Refresh at least every 12 months and sooner after a material event.
What is a 409A valuation?
A 409A valuation is a documented appraisal of the fair market value of a private company’s common stock on a given date. Companies use it to set the exercise price of employee stock options because an option granted below fair market value can be treated as deferred compensation under Section 409A.
The name comes from the tax code section, not from a single valuation method. The regulations require the reasonable application of a reasonable valuation method using information known or reasonably knowable on the valuation date.
How 409A Valuation works
| Step | What happens |
|---|---|
| 01 · Set the valuation date | Choose the date on which the common stock will be valued. The analysis may use only information known or reasonably knowable on that date. |
| 02 · Gather the evidence | Collect financial statements, forecasts, the capitalization table, recent transactions, financing terms, comparable company data and material developments. |
| 03 · Apply a reasonable method | Value the whole company, allocate that value between preferred and common stock, then consider an appropriate discount for lack of marketability. |
| 04 · Approve and use the value | The board reviews the report and sets option exercise prices at or above the common stock value. Refresh after 12 months or a material event. |
Section 409A exposure, with your numbers
Move the sliders to see what a discounted grant could cost the employee. This simplified illustration is federal only, ignores interest and assumes the value at vesting is the value selected.
Spread per option $2.00Additional 20 percent tax $4,000
Plus ordinary income tax on the spread and premium interest. Set the exercise price at or above the value on the grant date and every figure here is zero.
A worked example with numbers
A private company closes a Series A at $10.00 per preferred share. The appraiser allocates value across the capital structure and concludes that common stock is worth $3.00 per share. The board grants 10,000 options with a $3.00 exercise price, so there is no discount on the grant date.
If the same options were granted at $1.00 while common stock was worth $3.00, the $2.00 spread across 10,000 options would be $20,000. The simplified additional 20 percent federal tax would be $4,000 before ordinary income tax and premium interest.
Six months later, a major financing and changed forecasts provide new evidence. The company refreshes the analysis before making new grants. The 12 month rule is a ceiling, not a guaranteed shelf life.
Why it matters
Section 409A was written for deferred compensation, but a stock option granted at a discount to fair market value can fall inside it. The spread may be included in the employee’s income when the option vests, with an additional 20 percent federal tax and premium interest. Some states can add their own charge.
A supportable valuation is therefore the difference between a clean employee incentive and a tax problem. Company specific forecasts can be one input. To explore how forecast cash flows affect an estimated present value, use the DCF Valuation Tool. It is educational and is not a substitute for a qualified appraisal or tax advice.
Understand the stock behind the option
Options only pay when the common stock is worth more than the strike. Lesson 1 of the free course starts with how shares are valued and what preferences do to common stock.
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The three safe harbor approaches
Each approach can earn a rebuttable presumption that the valuation is reasonable. The IRS can still challenge it by showing the method or its application was grossly unreasonable.
| Approach | Core condition | Typical use |
|---|---|---|
| Independent appraisal | A qualified independent appraiser produces a written valuation no more than 12 months before the grant | Most venture backed private companies |
| Generally applicable repurchase formula | A formula used consistently for compensatory and noncompensatory purposes | Limited cases with a genuine standing formula |
| Illiquid start up valuation | A qualified person prepares a written report and the detailed age, market and liquidity conditions are met | Eligible early stage companies |
When to refresh, and how to run it
A company obtains or refreshes a valuation before its first option grants, at least every 12 months while it keeps granting options, and sooner after a material event such as a financing, acquisition offer, major customer change, forecast revision or litigation. Start the refresh before planned grant dates, keep the capitalization table and forecasts current, disclose material developments and record the board’s review.
What this means for employees
The 409A value sets the strike price. It does not say what the shares are worth today or guarantee what an employee will receive in an exit. Three prices can differ: the preferred price investors paid, the common stock fair market value used for the strike and the eventual sale price. A lower common value relative to the preferred price is normal because preferred stock has additional rights.
A practical company checklist
Use the valuation as a controlled process rather than an annual document exercise:
- Start the refresh before planned grant dates
- Keep the capitalization table, financial statements and forecasts current
- Tell the appraiser about material developments
- Document the board’s review and approval
- Calendar the 12 month anniversary and monitor events continuously
- Use specialist valuation and tax advice for technical questions
Comparison
| Aspect | 409A valuation | Fundraising valuation |
|---|---|---|
| Purpose | Support the common stock exercise price for tax compliance | Set the negotiated price of preferred stock in a financing |
| Security valued | Common stock | Preferred stock with liquidation preferences and other rights |
| Example price | $3.00 per common share | $10.00 per preferred share |
| When it changes | At least annually and after a material event | At each financing round |
Check yourself
Which event most clearly means a company should revisit an existing 409A valuation before the 12 month anniversary?
A material event can make the previous valuation unreliable before 12 months have run. A new financing is the clearest example because it provides fresh market evidence and changes the capital structure.
Show the answer
A new financing round that materially changes the company’s facts and value
Things people get wrong
Mistake 01 Using the funding round price as the common stock value
Preferred stock carries liquidation preferences and other rights that common stock does not, so the two prices are not interchangeable.
Mistake 02 Treating 12 months as a shelf life
A financing, acquisition offer, major commercial milestone or forecast change can make the old conclusion unreliable before 12 months have passed.
Mistake 03 Treating safe harbor as IRS approval
A safe harbor creates a rebuttable presumption of reasonableness. The IRS does not review or approve each report.
Questions people ask about 409A Valuation
What is a 409A valuation used for?
Private companies use it to establish the fair market value of common stock when setting exercise prices for employee stock options.
How much does a 409A valuation cost?
Provider guides published in 2026 commonly quote several thousand dollars, with price depending on company stage, complexity and provider. Some capitalization table platforms bundle a report with their subscription.
How often does a company need a new 409A valuation?
At least every 12 months while it is granting options under the independent appraisal safe harbor, and sooner after a material event such as a financing.
Is a 409A valuation the same as a fundraising valuation?
No. A financing prices preferred stock with additional rights, while a 409A analysis values common stock for compensation purposes.
Does the IRS approve each 409A valuation?
No. The company and its advisers are responsible for the valuation. A safe harbor shifts the burden of proof but is not an approval.
What happens if an option is granted below fair market value?
The spread may be included in income when the option vests, with an additional 20 percent federal tax plus premium interest. State consequences can also apply.
Does a 409A valuation apply to incentive stock options?
Incentive stock options are excluded from Section 409A but still must generally be granted at or above fair market value to qualify under Section 422.
Can a company prepare the valuation itself?
A limited illiquid start up approach can use a qualified person with relevant experience when detailed conditions are met. Most venture backed companies use an independent appraiser.
The bottom line
A 409A valuation is a dated, evidence based estimate of what a private company’s common stock is worth, used to set option exercise prices that stay outside Section 409A. It is often a fraction of the funding round price by design, it expires after 12 months or a material event, and getting it wrong can land on the employee as income plus a 20 percent additional tax.
Sources
- 26 CFR §1.409A-1, definitions and stock rights
- IRS, Final Section 409A Regulations, Internal Revenue Bulletin 2007-19
- IRS, Employer’s Supplemental Tax Guide, Publication 15-A
- IRS, Topic No. 427, Stock Options
- 26 U.S.C. §409A, nonqualified deferred compensation
- Eqvista, Cost of 409A Valuation in 2026
- Indinero, 409A Valuation Cost in 2026
How we produced the figuresThe worked example is illustrative: a $10.00 preferred price, a $3.00 appraised common value and a 10,000 option grant. Exposure is options multiplied by the amount by which the common stock value at vesting exceeds the exercise price; the additional federal tax shown is 20 percent of that amount. Ordinary income tax, premium interest, later appreciation and state tax are excluded.
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About this page. Written by Associate Professor Charles Lo, CPA, PhD and edited by Felix La Spina. Checked against reliable sources before publication. No ads and no paywall. Editorial standards · How we fact check · Corrections log · Report an error
Educational information only. Nothing on this page is personal financial, tax or legal advice. Investing involves risk, including the possible loss of principal.
