409A Valuation Explained for Founders

A 409A valuation is an independent appraisal of what one share of your startup's common stock is worth. US companies use it to set the strike price of employee stock options, because options granted below fair market value can be treated as deferred compensation that fails Section 409A of the Internal Revenue Code, and that failure hits your employees with extra taxes. If you plan to grant options, you need a defensible 409A valuation before the board approves the first grant.

This guide covers when founders need a 409A valuation, how the safe harbor works, what the appraiser looks at, cost and timing, a worked example, and the penalties for getting it wrong. It is general information, not tax advice; involve your startup lawyer and tax adviser in equity decisions.

What is a 409A valuation and why does it matter?

Section 409A governs nonqualified deferred compensation. A stock option with an exercise price at or above the fair market value of the underlying stock on the grant date is generally outside 409A. An option priced below fair market value is a discounted option, and discounted options can be treated as deferred compensation that fails 409A.

Private companies have no market price, so the regulations give three safe harbor methods that are presumed reasonable. The one most venture-backed startups use is an appraisal by a qualified independent appraiser. As Carta's overview of 409A valuations describes, a valuation from an independent appraiser shifts the burden: the IRS would have to show the value was grossly unreasonable to challenge it.

409A safe harbor methods

Method	Who it suits	Key conditions
Independent appraisal	Most venture-backed startups	Qualified independent appraiser; valuation date no more than 12 months before the grant; no material change since
Illiquid startup method	Very early companies	Company in business under 10 years, no readily tradable securities, no reasonably anticipated change of control within 90 days or IPO within 180 days; prepared by someone with significant relevant experience
Binding formula	Rare in startups	Formula used consistently for all transfers of that stock, such as buy-sell agreements

Founders sometimes set the price themselves or use the last round's price per share for common. That gets no safe harbor presumption, and using the preferred price for common overprices options, which hurts recruiting.

When does a startup need a 409A valuation?

• Before the first option grant. Get the valuation, then have the board approve grants at or above that price.
• At least every 12 months while you continue granting.
• After a material event: closing a priced funding round, a significant acquisition offer, a large change in revenue or burn, a pivot, or a secondary sale of common stock at a different price.
• Before a big hiring wave if the last valuation is getting old.
• Not usually after SAFEs alone, though a large SAFE raise may still be material; ask your provider.

How a 409A valuation is done

1. Information request: cap table, charter and preferred stock terms, SAFEs and notes, financial statements, projections, recent financing documents, and a description of the business.
2. Enterprise value: the appraiser estimates the whole company's value using one or more approaches. For startups that recently raised money, the backsolve method (deriving value from the last round price) is common. Revenue-stage companies may also use an income approach (discounted cash flow) or a market approach (comparable companies or transactions, often using revenue or EBITDA multiples).
3. Equity allocation: the enterprise value is split among share classes, accounting for preferred stock's liquidation preference and other rights. Option pricing models or probability-weighted scenarios are typical.
4. Discount for lack of marketability: common stock in a private company cannot be easily sold, so a discount is applied.
5. Report: a written report with the fair market value per common share and the valuation date.
6. Board approval: the board reviews the report and grants options at or above that value.

The methods overlap with the ones used to value a small business for sale, but the output is the value of one common share, not the whole company.

Worked example: seed-stage startup

Illustrative numbers. A software startup closes a seed round selling Series Seed Preferred at $1.20 per share, at a $12 million post-money valuation. It has 10 million fully diluted shares after the round, and the preferred has a 1x non-participating liquidation preference.

Step	Result
Preferred price paid by investors	$1.20 per share
Backsolved enterprise value	About $12.0 million
Value allocated to common before discount	$0.52 per share (after accounting for preferred rights)
Discount for lack of marketability	30%
409A fair market value of common	About $0.36 per share

The board grants a new engineer 40,000 options at $0.36. If the company had instead used a founder-picked $0.10 strike, the options would be discounted by $0.26 per share, or $10,400 in total on the grant date, exposing the engineer to 409A penalties as the options vest. If it had used the $1.20 preferred price, the options would be overpriced, and the engineer would need the company to grow much more before the options were worth anything.

Real 409A results depend heavily on the appraiser's assumptions; common stock values at seed stage are often a fraction of the preferred price.

What happens if you get 409A wrong?

If a discounted option fails Section 409A, the consequences fall mainly on the employee. According to IRS guidance on Section 409A, including the Nonqualified Deferred Compensation Audit Technique Guide:

• Vested deferred amounts become includible in income in the year of failure, even if the option has not been exercised.
• An additional 20% income tax applies to that amount.
• Premium interest at the underpayment rate plus one percentage point may apply, calculated from when the compensation was first deferred or vested.
• The employer must report the amount (Form W-2, box 12, code Z for employees) and withhold income tax.

IRS correction programs can reduce the damage for some errors if they are caught quickly, which is another reason to keep valuations current.

409A and ISOs

Incentive stock options (ISOs) must also be granted at no less than fair market value, and only up to $100,000 worth of ISOs (measured at grant-date value) can first become exercisable in any calendar year; the excess is treated as nonqualified options. A current 409A gives you the value to measure against. Contractors and advisors cannot receive ISOs; they get nonqualified options. If you are unsure who counts as an employee, see our guide to W-2 vs 1099 workers.

409A timeline for a new startup

Milestone	What to do about 409A
Incorporation and founder stock	No 409A needed; founders usually buy stock at a nominal price and file 83(b) elections within 30 days
Adopting an option plan	Order a 409A before the first grant
First hires with options	Board approves grants at or above the 409A price
Pre-seed SAFEs	Ask the provider whether the raise is material; many companies refresh
Priced seed or Series A	New 409A after closing, before the next grants
Every 12 months	Refresh while you keep granting
Acquisition talks or secondary sales	Discuss with counsel; a new valuation may be needed

Coordinate grant timing with hiring. If you expect to close a funding round in the next few weeks, consider granting options before closing using the current valuation, or waiting until the new 409A is ready. Granting just after closing but before the refresh is the riskiest window.

409A, founder pay and payroll

A 409A valuation does not set founder salaries, but the same equity questions show up in payroll. Employees who exercise nonqualified options have ordinary income equal to the spread between the fair market value and the exercise price, and that income is reported on their Form W-2 with withholding. If you are about to hire your first employee and plan to offer options, line up the plan documents, board approval and 409A report before the offer is signed, so the grant can be made at the right price on the start date.

Common questions founders ask the appraiser

Expect to explain your revenue forecast, burn rate and runway, the terms of each preferred class, any secondary sales, and how likely an acquisition or IPO is within the next few years. Answer consistently with what you told investors. If your projections in the investor deck show rapid growth but you give the appraiser a flat forecast to keep the common price low, that inconsistency can undermine the valuation if it is ever reviewed.

Choosing a 409A provider: checklist

• Credentials of the appraisers (for example, ASA, ABV or CFA designations) and startup experience.
• Turnaround time, usually one to three weeks.
• Price and whether refreshes after material events cost extra.
• Audit support if the IRS or your acquirer's auditors question the value.
• Integration with your cap table software.

Common founder mistakes with 409A

• Promising options in an offer letter with a strike price before the valuation exists.
• Granting options after a priced round using the old, pre-round valuation.
• Letting the valuation lapse past 12 months during a hiring push.
• Delaying board approval, so the grant date falls after a material event.
• Providing rosy projections to the appraiser that do not match investor decks, or vice versa; consistency matters.

A 409A report is one more line item in your startup's spending. If you sell services or software while you grow, track that revenue cleanly and get paid faster by sending professional invoices from our free invoice generator: no sign-up, download as PDF.