What is a 409A valuation? Process, costs, and how to interpret it
- What is a 409A valuation?
- 409A valuation process: Step-by-step guide
- Key 409A valuation requirements
- How to evaluate your 409A valuation
- 409A valuation management best practices
- 409A valuation mistakes to avoid
- 409A valuation benchmarks by funding stage
- Save on your 409A valuation with Ramp and Pulley
A 409A valuation is an independent assessment of your company’s fair market value (FMV) used to set compliant strike prices for employee equity compensation under Internal Revenue Code Section 409A. When valuations are wrong or outdated, noncompliance can trigger significant IRS penalties, including a 20% additional federal tax on affected compensation, plus interest.
What is a 409A valuation?
A 409A valuation determines the fair market value of your company’s common stock for equity compensation purposes. It establishes what your shares are worth on the grant date so you can set stock option strike prices that comply with Internal Revenue Code Section 409A.
Section 409A exists to prevent companies from underpricing equity and deferring taxes improperly. The regulation governs nonqualified deferred compensation and requires stock options to be granted at or above fair market value. If the IRS determines options were priced below FMV, employees may face immediate income tax and additional penalties.
It’s also important to distinguish a 409A valuation from a fundraising valuation. A fundraising valuation reflects the price investors pay for preferred shares, which include rights and protections that common stock doesn’t have. A 409A valuation adjusts for those differences and applies appropriate discounts to arrive at a defensible fair market value for common stock.
Any private company issuing equity compensation needs a 409A valuation. This includes startups granting stock options for the first time, growing companies expanding their equity plans, and mature private companies issuing ongoing equity awards.
When do you need a 409A valuation?
You don’t need a new valuation every time you grant equity, but you do need one in place before setting strike prices in specific situations.
- First-time equity grants: If you’re issuing stock options for the first time, you need a 409A valuation before making any grants. Without it, you won’t qualify for safe harbor protection and may expose employees to tax risk from the outset.
- Material events: Certain events materially affect your company’s value and invalidate prior valuations. These include new funding rounds, mergers or acquisitions, significant revenue changes, or shifts in your business model.
- Annual refresh: Even if nothing significant changes, a 409A valuation expires after 12 months
409A valuation process: Step-by-step guide
A typical 409A valuation takes about 2–4 weeks from kickoff to final report, depending on your company’s complexity and how prepared your data is. Understanding each step of the process makes it easier to evaluate whether the final valuation is reasonable and defensible.
Step 1: Select a valuation provider
Choosing the right provider shapes the quality and defensibility of your valuation. Not all providers offer the same level of rigor, documentation, or safe harbor protection.
- Independent third-party valuation firms: These firms specialize in compliance-driven analyses and typically provide strong safe harbor protection. They’re often the best fit for later-stage companies, complex cap tables, or businesses with frequent material events.
- Software-enabled valuation providers: These platforms combine automation with expert review to reduce cost and turnaround time. They can work well for early-stage startups with simpler equity structures, as long as independence requirements are met.
Look for providers with experience in your industry, clear methodology documentation, and credentials that stand up to investor and IRS scrutiny. Costs typically range from $2,000 to $10,000 or more, depending on company size, complexity, and urgency.
Capitalization table
A capitalization table is a record of who owns what in your company and how that ownership changes over time. A cap table lists all equity holders, founders, employees, and investors, and shows how much of the company each owns, both on a fully diluted and as-issued basis.
Step 2: Gather information and documents
Valuation accuracy depends heavily on the quality of the information you provide. Incomplete or outdated inputs often result in overly conservative assumptions that can skew your fair market value.
Providers typically request the following materials:
- Financial statements: Income statements from the past 12 to 24 months, balance sheets, and cash flow statements
- Capitalization table: A complete view of equity ownership, including option pools, preferred stock terms, and liquidation preferences
- Business plan and projections: Forward-looking forecasts that reflect how management expects the company to perform
- Recent or pending funding activity: Details on financing rounds, term sheets, or investor negotiations that may signal changes in valuation
Step 3: Apply valuation methodologies
Most 409A valuations rely on multiple methodologies, which are weighted based on your company’s stage, industry, and data availability. The goal is not to force a single number, but to reconcile different perspectives into a defensible fair market value.
Common approaches include:
- Market approach: Compares your company to similar public or private companies, adjusting for size, growth, and risk
- Income approach: Estimates future cash flows and discounts them to present value using a risk-adjusted rate, which is common when revenue and projections are more predictable
- Asset approach: Focuses on the net value of assets minus liabilities and is typically used for asset-heavy or very early-stage companies
Valuation providers determine how much weight to give each method based on relevance and reliability, then reconcile the results into a final FMV conclusion.
Key 409A valuation requirements
To comply with IRS rules, a 409A valuation must meet three core requirements: it must follow accepted valuation principles, be performed by an independent party, and be supported by clear documentation. Meeting these standards is what allows companies to rely on safe harbor protections.
Independence is critical. Anyone with a material financial interest in the company can’t prepare the valuation, including founders, employees, or investors. Using an independent provider shifts the burden of proof to the IRS if the valuation is ever challenged.
Documentation matters just as much as the valuation itself. You should retain the full valuation report, supporting assumptions, and underlying data so you can substantiate fair market value during audits, due diligence, or internal reviews. Proper recordkeeping also simplifies compliance when you need to prepare an audit.
Valuations must also be refreshed on a regular schedule. A 409A valuation is valid for up to 12 months unless a material event occurs sooner, at which point the prior valuation can no longer be relied on for new equity grants.
What triggers revaluation
Certain changes invalidate your existing 409A valuation and require a new one before issuing additional equity.
- New funding rounds: Investor pricing introduces new signals that affect fair market value
- Significant revenue changes: Rapid growth or unexpected declines can materially alter valuation assumptions
- Major acquisitions or divestitures: Transactions that change risk profile or future outlook require reassessment
- Secondary market transactions: Sales of common stock may indicate shifts in perceived value
How to evaluate your 409A valuation
Once you receive your valuation report, don’t treat it as a box-checking exercise. Evaluating a 409A valuation means understanding how the provider arrived at the number and whether the assumptions reflect your company’s current reality.
Start by reviewing the overall structure of the report, including the company overview, selected methodologies, key assumptions, and final conclusions. Pay particular attention to how preferred stock rights were allocated and how discounts were applied to arrive at a common stock fair market value.
409A valuation: Critical factors to assess
Certain assumptions have an outsized impact on your valuation. Reviewing these areas closely helps you identify whether the outcome is reasonable and defensible.
| Factor | What it measures | Why it matters |
|---|---|---|
| Discount for lack of marketability (DLOM) | The reduced value of private shares due to limited liquidity | Unusually high or low discounts can materially skew FMV and raise questions during audits or diligence |
| Volatility assumptions | Expected price fluctuation used in valuation and option pricing models | Using public comparables that don’t match your company’s risk or growth profile can distort results |
| Comparable company selection | The peer companies used in the market approach | Comps that are too large, too mature, or in a different industry undermine credibility |
| Revenue and growth projections | Forecasts underlying income-based models | Projections should align with internal plans and board-approved forecasts |
Evaluating your 409A valuation: Red flags to watch for
These warning signs warrant closer scrutiny or follow-up with your valuation provider:
- Valuations far below recent funding rounds: Large gaps without clear justification may indicate overly conservative assumptions
- Outdated financial inputs: Using stale data weakens defensibility
- Weak comparable analysis: Missing or poorly explained comps reduce credibility
- Limited methodology transparency: A lack of explanation makes it harder to rely on safe harbor protections
409A valuation management best practices
Managing 409A valuations is an ongoing process, not a one-time compliance task. Strong valuation management reduces risk, supports equity planning, and makes it easier to scale your equity program as the company grows.
Establish a valuation refresh schedule
A consistent refresh schedule helps you stay ahead of compliance deadlines and avoid last-minute delays. Most companies plan annual valuations and build in checkpoints around expected material events so they aren’t scrambling to update valuations when new hires or grants are approved.
Aligning your refresh cadence with board meetings and equity planning cycles also simplifies coordination. When timing is predictable, it’s easier to gather data, secure approvals, and communicate changes internally.
Maintain proper documentation
Complete documentation supports safe harbor protection and simplifies audits and diligence. Keep valuation reports, supporting assumptions, and correspondence with providers in a centralized location so they’re easy to reference when needed.
Good recordkeeping also helps during leadership transitions or auditor reviews. Historical context makes it easier to explain how and why fair market value has changed over time.
Coordinate with legal and tax advisors
Legal and tax advisors help validate assumptions, confirm compliance, and flag potential risks before equity grants are issued. Regular coordination ensures valuation practices remain aligned with evolving regulations and company circumstances.
This collaboration is especially important after funding rounds or structural changes. Early input helps prevent issues that are harder to unwind later.
Communicate with employees about strike prices
Employees often focus on strike prices without understanding how they’re determined. Clear communication builds trust, especially after funding rounds or valuation updates.
Explaining that strike prices are set by independent valuations, not arbitrary decisions, reinforces the credibility of your equity program and reduces confusion.
409A valuation mistakes to avoid
Failing to stay on top of your 409A valuation can lead to serious financial and compliance consequences. These are some of the most common mistakes companies make.
- Delaying valuations after funding rounds: Waiting too long to update a valuation after new financing can invalidate prior assumptions and expose new equity grants to compliance risk
- Using non-independent valuations: Valuations prepared by insiders or parties with a financial interest don’t qualify for safe harbor protection
- Ignoring material events: Revenue spikes, acquisitions, or secondary transactions between annual refreshes can invalidate a valuation
- Relying on outdated financials: Using projections that no longer reflect current performance weakens defensibility
- Poor documentation practices: Incomplete records make audits and reviews harder to defend and increase risk, especially when bookkeeping is inconsistent
409A valuation benchmarks by funding stage
A company’s fair market value directly affects option strike prices and varies widely based on revenue, growth, and industry. These benchmarks reflect common ranges seen across startup 409A valuations, not fixed rules.
- Seed-stage funding: Companies raising on SAFEs or convertible notes often see fair market value at roughly 20–50% of their valuation cap. For example, a $20 million valuation cap may result in a common stock valuation closer to $4 million.
- Series A–B: Fair market value typically ranges from 50–80% of the pre-money valuation. A $500 million pre-money valuation could correspond to a common stock valuation near $250 million.
- Series C and beyond: Later-stage valuations are highly company-specific, with smaller discounts than earlier rounds. At this stage, auditors often assess expectations based on financial performance and long-term planning, including your startup budget.
As with any valuation, setting an unrealistically low fair market value can create significant tax risk. If the IRS determines your strike prices don’t reflect defensible fair market value, it may treat discounted equity as taxable income and impose a 20% penalty, plus interest.
Go low but defensible
A common misconception about 409A valuations is that the goal is to get the lowest possible strike price. That approach can expose both the company and employees to serious tax risk. The real goal is to arrive at the lowest defensible fair market value that can withstand IRS scrutiny and comply with Internal Revenue Code Section 409A.
Save on your 409A valuation with Ramp and Pulley
Ramp partners with Pulley to help you save on the cost of your 409A valuations. If you use the Ramp Business Credit Card or other products under our finance automation platform, you can get 25% off your first year with Pulley, including its 409A valuation services.
Pulley works with trusted experts in 409A valuations to get you a fast, fair, and accurate 409A valuation. Its partners have 100% audit-proof defensibility against the IRS and the Big Four firms, and Pulley provides a lifetime guarantee on all of its reports.
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The information provided in this article does not constitute legal or financial advice and is for general informational purposes only. Please contact an attorney or financial advisor to obtain advice with respect to the content of this article.
FAQs
Once you submit the required documentation, it may take a few weeks to a month for a valuation firm to deliver a 409A valuation. The timeline can vary based on your startup’s complexity, the completeness of your business documentation, the responsiveness of the valuation firm you choose, and other factors.
A 409A safe harbor means the IRS considers your 409A valuation reasonable if an independent appraiser completed it within 12 months of granting stock options. This provides a layer of protection against IRS challenges unless the valuation is proven to be grossly unreasonable.
A 409A valuation determines the FMV of your company’s common stock for IRS compliance and setting employee stock option strike prices. A funding valuation reflects your company’s value after an investment round based on the price investors paid for preferred shares. The 409A is typically lower, protecting employees with defensible strike prices, while the funding valuation drives investor negotiations and ownership stakes.
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