What matters in a 409A valuation

Why your 409A matters

A 409A valuation determines the fair market value of your company's common stock, and that number becomes the strike price for the options you grant. Set the price too low and you risk tax problems for the employees who receive the options. Set it carelessly and you risk hard questions from auditors and investors later.

The IRS generally presumes a valuation is reasonable when it is prepared by a qualified independent appraiser, is no more than 12 months old, and reflects all material information available at the time. The IRS can overcome that presumption only by showing the valuation was grossly unreasonable. That presumption is the main reason founders commission an independent report instead of picking a number themselves.

When you need a new 409A

Plan for a new valuation at least once every 12 months. A valuation can also go stale sooner if something material changes. Common triggers include:

If a material event happens, check whether your valuation still holds before you make the next grant. Granting options on a stale valuation is one of the most common ways companies end up with a problem.

What a strong 409A report shows

A report does not need to be long, but it should let a reader follow how the conclusion was reached. Look for:

• A clear valuation date and a statement that the standard of value is fair market value.
• A description of your company and a cap table that matches your records.
• The valuation approach and why it was chosen for your stage: market, income, asset, or a combination.
• How value is allocated across preferred and common stock, for example with an option pricing model, a probability-weighted scenario analysis, or a hybrid of the two.
• Support for the discount for lack of marketability, which reflects that private shares cannot be sold easily.
• A reconciliation to your most recent financing, with an explanation of any differences.
• The appraiser's qualifications and a statement of independence.

Red flags

• No explanation of how the latest financing price relates to the value of common stock.
• A cap table that does not match yours, or inputs you were never asked to confirm.
• Comparable companies that do not resemble your business or stage.
• A marketability discount stated without support.
• Assumptions that are not disclosed, or conclusions that do not follow from the analysis.

What auditors look for

If your financial statements include stock-based compensation expense under ASC 718, your auditors will rely on this report. They tend to look for:

• A valuation date that sits sensibly against your grant dates.
• Consistency with your financing history and financial statements.
• Documented support for the key assumptions.
• Evidence that the appraiser considered events after the valuation date.
• A qualified, independent preparer.

Common mistakes founders make

• Waiting until the valuation expires. Ordering a new report only when the old one lapses can leave a gap in which you cannot grant options with confidence.
• Ignoring material events. A financing, an offer, or a big swing in results can make a valuation stale before its 12 months are up.
• Giving incomplete inputs. A report is only as accurate as the cap table and financials behind it. Reconcile your cap table before you share it.
• Choosing on price or speed alone. A low price or fast turnaround means little if the report cannot answer an auditor's questions. Ask who prepares and reviews it.
• Treating it as paperwork. Read the report, understand the key assumptions, and ask questions before you rely on it.

How a 409A is built

Whatever the format, a valuation follows the same logic.

1. Gather inputs. Your cap table, financial statements, financing documents, and plan for the business.
2. Estimate enterprise value. Using the market, income, or asset approach, as appropriate to your stage.
3. Allocate value to share classes. Preferred stock carries rights that common stock does not, so common stock is typically worth less per share than the latest preferred price.
4. Apply a marketability discount. Private common shares are hard to sell, so the value is reduced to reflect that.
5. Review and document. The conclusion is reviewed and written up so a third party can follow it.

What happens when a 409A goes wrong

If a valuation was not reasonable and the IRS challenges it, options granted at that price can be treated as deferred compensation that does not comply with Section 409A. For the employee, that can mean income tax as the options vest, an additional 20% federal tax, and interest, and some states add their own penalties. For the company, it can mean withholding and reporting obligations, difficult conversations with employees, and friction in diligence for a financing or a sale.

If you suspect a problem, act early:

• Identify which grants relied on the questionable valuation.
• Commission a new, well-supported valuation.
• Talk to your tax advisor and counsel about whether and how the affected grants can be corrected.

How we approach it at Fairstrike Equity

Every valuation at Fairstrike Equity is prepared by our in-house team of valuation experts with 20+ years of experience and reviewed by a director before delivery. We document our methodology and assumptions so your board, auditors, and investors can follow the reasoning, and we are glad to walk you through the report. We aim to deliver a first draft in 3–5 business days once we have your information, and we confirm timing up front.

Questions to ask any valuation provider

• Who prepares the valuation, and who reviews it?
• Is the work done in-house or outsourced?
• Which approach and allocation method will you use, and why?
• How will you support the marketability discount?
• What happens if my auditor or investor has questions about the report?