409A Valuation Explained: Complete Guide

Last Updated: January 2026

What Is 409A Valuation?

A 409A valuation is an independent appraisal that determines the fair market value (FMV) of a private company's common stock. Named after Section 409A of the Internal Revenue Code, this valuation is required for private companies that offer stock options or other equity compensation to employees.

The 409A valuation serves a critical regulatory purpose: it establishes the strike price (exercise price) for stock options. IRS rules require that options be granted with a strike price at or above the fair market value of the underlying stock on the grant date. If options are granted below FMV, they can be subject to immediate taxation and penalties under Section 409A.

Key characteristics of 409A valuations:

• Independent appraisal: Must be performed by qualified, independent valuation firm
• Common stock focus: Values common stock (what employees receive), not preferred stock (what investors buy)
• Safe harbor protection: Following 409A valuation provides legal protection from IRS penalties
• Conservative by nature: Methodology intentionally produces lower valuations than investor pricing
• Annual requirement: Must be updated at least annually or after material events

Who Performs 409A Valuations?

Companies hire specialized valuation firms to conduct 409A appraisals. Leading providers include:

• Carta (integrated with cap table management)
• Pulley
• Aranca
• Scalar
• Big Four accounting firms (Deloitte, EY, KPMG, PwC) for larger companies

Cost: $2,000-$5,000 for early-stage companies, $5,000-$15,000+ for later-stage companies, depending on complexity.

Legal Foundation: Section 409A

Section 409A of the Internal Revenue Code was enacted in 2004 following corporate scandals (Enron, Tyco) where executives backdated stock options to increase personal gains at expense of shareholders. The rule created strict requirements for deferred compensation, including stock options.

409A penalties for non-compliance:

• Options granted below FMV trigger immediate taxation
• Option holder pays ordinary income tax on spread, PLUS 20% penalty, PLUS interest
• Taxes due at vesting, not exercise (extremely unfavorable)
• Can cost employees thousands to hundreds of thousands in unexpected taxes

Safe harbor protection: If company obtains independent 409A appraisal and uses that valuation for option grants, the IRS presumes the valuation is reasonable and won't challenge it absent evidence of fraud or manifest error. This makes 409A valuations effectively mandatory for private companies issuing equity.

Why 409A Valuation Exists

Understanding the policy rationale behind 409A helps explain why the methodology produces conservative valuations.

Preventing Backdating Abuse

Before 409A, companies could grant options with artificially low strike prices by:

• Backdating grants to earlier dates when stock price was lower
• Cherry-picking arbitrary "fair market values" with no supporting analysis
• Granting options at $1 when stock was actually worth $10

This effectively gave employees free compensation without proper taxation. Section 409A eliminated this by requiring contemporaneous, independent valuations.

Protecting Employees

409A also protects employees by ensuring they're not receiving options that trigger unexpected tax liabilities. By setting strike prices at true FMV:

• Options have no built-in gain at grant (no immediate tax)
• All gain occurs after grant, eligible for capital gains treatment
• Employees know exactly what they're getting

Protecting the IRS

The IRS wants to ensure option compensation is properly valued and taxed. Conservative 409A methodology ensures:

• Strike prices aren't artificially depressed
• Government doesn't lose tax revenue from under-valued compensation
• Consistent, defensible valuation standards

409A Valuation vs Funding Round Valuation

This is the source of most confusion. Your company can legitimately have two very different valuations simultaneously, and both can be "correct" for their purposes.

Funding Round (Preferred Stock) Valuation

What investors pay: Price per share in funding rounds (Series A, B, C, etc.)

Example: Company raises $100M Series C at $15.00 per preferred share = $3 billion post-money valuation

Why it's high:

• Investors buy preferred stock with valuable rights:
  • Liquidation preference: Get money back first in exit
  • Anti-dilution protection: Protected against down rounds
  • Board seats and control: Governance rights
  • Information rights: Access to financial data
  • Pro-rata rights: Ability to participate in future rounds
• Negotiated in competitive process (multiple investors bidding)
• Reflects forward-looking growth expectations
• Market-driven pricing (supply/demand for hot companies)

409A (Common Stock) Valuation

What employees get: Fair market value of common stock

Example: Same company's 409A values common stock at $6.00 per share

Why it's lower:

• Common stock has none of the preferred rights:
  • Last in line for liquidation (preferred get paid first)
  • No downside protection
  • Minimal control or governance rights
  • Limited information rights
• Illiquid (can't easily sell private shares)
• Long time horizon to liquidity (3-7+ years to IPO/exit)
• Conservative methodology required by IRS
• Based on current value, not future potential

Typical Discount: Preferred to Common

The discount narrows over time as:

• Company matures and de-risks
• Path to liquidity becomes clearer
• Liquidation preferences become less meaningful (exit values exceed preferences by wide margin)
• IPO date approaches (common converts to publicly traded stock)

Real-World Example

Series C SaaS Company:

• Funding round: Raised $150M at $20.00/share preferred = $4B post-money valuation
• 409A valuation: Common stock valued at $12.50/share = 62.5% of preferred
• Implied common valuation: $2.5B (if applied to all shares)
• Discount rationale:
  • $500M in liquidation preferences ahead of common
  • 3-4 years estimated to IPO (illiquidity discount)
  • Uncertain path to exit (execution risk)

For employees: If you own 10,000 shares, your equity is worth 10,000 × $12.50 = $125,000 today (409A value), with potential upside to 10,000 × $20+ = $200K+ if company achieves successful exit.

How 409A Valuation Is Calculated

409A valuations use sophisticated financial models to allocate enterprise value across different share classes and apply appropriate discounts.

Valuation Methods

Valuation firms use three primary methodologies, typically blending all three for final valuation:

1. Market Approach

• Compare company to publicly traded peers (similar size, industry, growth, profitability)
• Apply public company valuation multiples (EV/Revenue, EV/EBITDA) to private company metrics
• Adjust for differences (growth rate, margins, market position)
• Apply illiquidity discount (25-40% typical) for private shares

Example:

• Public SaaS peers trade at 8x revenue
• Private company: $100M revenue
• Implied value: $800M
• Less 30% illiquidity discount = $560M enterprise value

2. Income Approach (DCF)

• Project future cash flows (5-10 years)
• Calculate terminal value (cash flows beyond projection period)
• Discount to present value using weighted average cost of capital (WACC)
• Reflects intrinsic value based on future cash generation

Less commonly used for high-growth, pre-profitable companies (no cash flows to discount), but important for mature private companies.

3. Backsolve Method (Most Common)

• Start with recent preferred funding round as anchor
• Use option pricing models to allocate value across share classes
• "Solve backward" from known preferred price to determine common value
• Most relevant when recent funding occurred (within 6-12 months)

Option Pricing Models (OPM)

The backsolve method uses option pricing models to allocate enterprise value between preferred and common stock. This is complex financial modeling, but the concept is:

Key insight: Common stock can be viewed as a call option on the enterprise value, with a "strike price" equal to the liquidation preferences of all preferred stock ahead of it.

• If company exits below liquidation preferences, common gets $0 (option expires worthless)
• If company exits above liquidation preferences, common participates in upside (option has value)

Black-Scholes Option Pricing Model:

• Treats common stock as call option on enterprise value
• Inputs: Enterprise value, volatility, time to exit, liquidation preferences, risk-free rate
• Outputs: Value of common stock per share

Probability-Weighted Expected Return Method (PWERM):

• Model multiple exit scenarios (IPO, acquisition, stay private, bankruptcy)
• Calculate common stock value in each scenario
• Weight by probability of each scenario
• More detailed than Black-Scholes but more subjective (requires scenario probabilities)

Key Inputs and Assumptions

Enterprise value:

• Total value of company (all equity)
• Derived from recent funding round, market approach, or DCF

Volatility:

• Expected variability in future enterprise value
• Higher volatility = higher option value (more chance of big upside)
• Estimated from comparable public companies (30-60% typical for tech)

Time to liquidity:

• Expected years until IPO, acquisition, or other exit
• Longer time = lower common value (more discounting, more uncertainty)
• Typical assumptions: 3-5 years for growth companies, 1-2 years for late-stage

Liquidation preferences:

• Total dollars preferred shareholders get paid before common
• Higher liquidation preferences = lower common value (higher "strike price")

Discount for lack of marketability (DLOM):

• Additional discount for illiquidity of private shares
• 10-30% typical, depending on stage and secondary market activity

Weighting the Methods

Valuation firms typically use multiple methods and weight them:

Example weighting (Series B company with recent funding):

• Backsolve method: 60% weight (most relevant—recent funding provides market data point)
• Market approach: 30% weight (validates reasonableness vs. public peers)
• Income approach: 10% weight (sanity check, but less reliable for high-growth pre-profit)

Example weighting (late-stage company, no recent funding):

• Market approach: 50% weight
• Income approach (DCF): 30% weight (more reliable as company approaches profitability)
• Backsolve: 20% weight (stale funding round from 18 months ago)

What 409A Valuation Means for Employees

For employees receiving equity compensation, the 409A valuation directly impacts the value and tax treatment of your grants.

Sets Your Strike Price (Options)

When company grants you stock options, the strike price must equal or exceed the 409A fair market value on the grant date.

Example:

• Most recent 409A: $8.00 per share
• You receive option grant in March 2026
• Your strike price: $8.00 per share (or higher, but typically at 409A)
• You own 10,000 options at $8.00 strike

What this means:

• When options vest, you can exercise by paying $8.00 × 10,000 = $80,000
• If company later valued at $20/share, your paper gain = 10,000 × ($20 - $8) = $120,000
• Lower 409A = lower strike price = more gain potential for employees

Determines Current Value of Your Equity

409A valuation is the best estimate of what your vested shares are worth today.

Calculating your equity value:

• Vested options: (409A price - strike price) × vested option count = current value
• Vested shares: 409A price × share count = current value
• Unvested grants: No current value (you don't own them yet)

Example:

• 10,000 options granted at $2 strike price
• 5,000 have vested (owned), 5,000 unvested
• Current 409A: $12.00
• Your equity value: 5,000 vested × ($12 - $2) = $50,000
• Potential future value if all vest: 10,000 × ($12 - $2) = $100,000 (at current 409A; could be much higher at exit)

Lower 409A = Better for Employees

Employees benefit from lower 409A valuations because:

• Lower strike prices: New option grants have lower strike prices, increasing gain potential
• Lower exercise costs: Cheaper to exercise options and buy shares
• Lower AMT: Smaller spread between FMV and strike price reduces AMT liability on ISO exercises

Example illustrating the benefit:

Lower strike price = $50,000 more gain at exit.

Company incentive: Companies want lower 409A valuations to provide more valuable equity to employees. However, they can't manipulate valuations—independent appraisers follow IRS-compliant methodology.

409A and RSUs

For RSUs (Restricted Stock Units), 409A determines the taxable income when RSUs vest:

• RSUs vest at certain dates
• At vesting, FMV (409A value) is treated as taxable W-2 income
• Company withholds taxes by keeping some shares

Example:

• 1,000 RSUs vest in March 2026
• 409A value at vesting: $15.00 per share
• Taxable income: 1,000 × $15 = $15,000
• Withholding (37% in high tax bracket): $5,550
• Company withholds 370 shares to cover taxes
• You receive 630 shares

When 409A Valuations Must Be Updated

409A valuations aren't permanent—they must be refreshed regularly to reflect company progress and market changes.

Annual Refresh Requirement

IRS safe harbor requires 409A valuations be updated at least annually. Companies typically refresh:

• Every 12 months from last valuation
• On calendar year basis (e.g., every January)
• On fiscal year basis

Valuations older than 12 months lose safe harbor protection, exposing company to IRS challenge.

Material Events Requiring Update

Companies must obtain new 409A valuation after "material events" that significantly affect company value:

Fundraising events:

• New funding round: Always requires 409A update (new preferred price = new data point for backsolve)
• Down round: Must update to reflect reduced valuation
• Bridge financing: May require update depending on terms

Company milestones:

• Major product launch: New revenue stream affects valuation
• Large customer wins: Revenue trajectory changed
• Strategic partnerships: Material impact on business prospects

Financial changes:

• Profitability achieved: De-risks business significantly
• Major revenue growth: 2x+ revenue milestone
• Cash runway concerns: Running low on cash affects value

M&A activity:

• Acquisition offers: Market interest affects valuation
• IPO preparations: Filing S-1 triggers update (409A should converge toward IPO price)

Negative events:

• Key executive departures: Loss of leadership
• Product failures: Major setback in business
• Competitive threats: Market position eroded

Strategic Timing of 409A Updates

Companies have some discretion on timing within the annual window:

Delay updates when:

• Planning large option grants soon (wait until after grants to get update that might increase strike price)
• Recent negative events haven't yet been reflected (update would lower 409A and strike prices)

Accelerate updates when:

• Recent positive milestones justify higher valuation (want to show employees equity appreciation)
• Approaching fundraise and want current valuation aligned

Ethical note: While companies can time updates strategically within reasonable bounds, they cannot manipulate valuations or ignore material events to artificially benefit insiders.

Pre-IPO 409A Updates

As companies approach IPO, 409A valuations should increasingly align with expected IPO price:

• 12 months before IPO: 409A might be 70-80% of expected IPO price
• 6 months before IPO: 80-90% of IPO price
• S-1 filing: 409A should be very close to IPO price range (within 10-20%)

Large discrepancies between 409A and IPO price can draw IRS scrutiny for recent option grants.

409A Valuation and Secondary Market Sales

409A valuations directly influence pricing in secondary market transactions where employees and early investors sell shares.

409A as Pricing Benchmark

Secondary market prices are typically expressed as multiple of 409A valuation:

• 0.8-1.0x 409A: Distressed companies, limited buyer interest, urgent sellers
• 1.0-1.2x 409A: Average companies, normal market conditions
• 1.2-1.5x 409A: High-quality companies with strong growth and IPO prospects
• 1.5-2.0x+ 409A: Exceptional companies (Stripe, SpaceX-tier) with near-term IPO potential

Example:

• Company's 409A: $10.00 per share
• Strong company with IPO in 12-18 months
• Secondary market price: $13.00 per share (1.3x 409A)
• Buyer willing to pay premium anticipating IPO at $20+ per share

Why Secondary Prices Exceed 409A

Secondary market prices often trade above 409A because:

• 409A is conservative: Methodology designed to be defensible to IRS, not reflect full market value
• Buyers are sophisticated: Accredited investors doing own diligence, willing to pay for growth potential
• Illiquidity discount less relevant: Buyers specifically seeking illiquid investments for their portfolios
• Option value: Buyers model upside scenarios (IPO pop), not just current value
• Supply/demand: Hot companies have more buyers than shares available (bidding war)

Using 409A to Evaluate Secondary Prices

When buying or selling unlisted shares:

For buyers:

• Ask for most recent 409A valuation and date
• If shares priced at 1.5x+ 409A, ensure company quality justifies premium
• Be wary if 409A is stale (12+ months old)—current value may be lower
• Compare to recent secondary transactions in same company

For sellers:

• Price shares at 1.0-1.3x 409A for reasonable, marketable pricing
• If company is exceptional, can seek 1.3-1.5x+ 409A
• Below 409A pricing may trigger company concerns (setting low precedent)

Company Approval and 409A

Companies reviewing secondary sales often reject transactions priced significantly below 409A because:

• Sets negative precedent for future sales and fundraising
• May indicate valuation problems if market won't pay 409A
• Can demoralize employees seeing their equity trade at discounts

Pricing at or above 409A increases likelihood of company approval.

Common Questions About 409A Valuations

Q: Can companies manipulate 409A valuations to benefit insiders?

A: Not easily. Independent valuation firms must follow IRS-compliant methodology and maintain professional standards. While companies provide inputs (financial projections, comparables), the valuation firm controls the methodology and must defend their work if challenged. Firms won't risk reputation and legal liability by producing indefensible valuations.

That said, companies have some influence through timing, input selection, and choosing more or less conservative assumptions within reasonable ranges. But egregious manipulation would expose company to IRS penalties and valuation firm to liability.

Q: Why is my company's 409A so much lower than the funding round?

A: This is normal and expected. Preferred stock (what investors buy) has liquidation preferences, anti-dilution protection, and other rights that make it more valuable than common stock (what employees receive). The discount is typically 40-60% at early stages, narrowing to 10-20% pre-IPO. See 409A vs Funding Valuation section for detailed explanation.

Q: Can I use 409A valuation to estimate my equity's exit value?

A: 409A tells you what your shares are worth today, not at future exit. At IPO or acquisition, common stock value depends on:

• Exit valuation (could be much higher or lower than today)
• Liquidation preferences (how much preferred gets paid first)
• Exit structure (cash vs. stock, earnouts, etc.)

Use 409A as current value baseline, but model various exit scenarios to understand potential outcomes. See Private Company Valuation Guide.

Q: What happens if company doesn't get 409A valuation?

A: Company loses safe harbor protection. IRS can challenge option strike prices, and if deemed below FMV:

• Option holders face immediate taxation on spread
• 20% penalty tax plus interest
• Taxes due at vesting, not exercise
• Extremely unfavorable tax treatment

Virtually all venture-backed companies obtain 409A valuations—it's considered mandatory risk management.

Q: Do public companies need 409A valuations?

A: No. Public companies have readily determinable fair market value (the stock price on the exchange). They use closing stock price on grant date as strike price for options. 409A applies only to private companies without public market pricing.

Q: Can employees request copy of 409A report?

A: Companies are not required to share full 409A reports with employees. Most will share:

• Per-share 409A valuation (the number you need)
• Valuation date
• Basic methodology

Full reports contain confidential financial projections and strategic information companies may not want widely distributed. If you have significant equity stake, you can request more detail, but company may decline.

Q: Does 409A valuation affect company's fundraising?

A: Not directly. Investors care about preferred stock price (what they're paying), not common stock 409A value. However:

• Large gap between 409A and preferred price (normal early-stage) shows healthy distinction
• Converging 409A and preferred prices (late-stage) indicate maturing company
• Stale 409A may signal company isn't actively managing equity compensation

Sophisticated investors review 409A reports during diligence to understand cap table and liquidation preferences.

Q: What if I think my company's 409A is wrong?

A: If you believe 409A is unreasonably low or high:

• Companies can request second opinions from different valuation firms
• If results differ significantly, company can choose which to adopt (within reason)
• IRS can challenge valuations, but burden is on IRS to prove methodology was unreasonable
• As employee, you have limited recourse—company controls the process

If you suspect fraud or manipulation, consult attorney, but this is rare at reputable companies.