What Is a 409A Valuation?
If you’re giving equity to employees or anyone else providing services to your company, the IRS wants you to know what that equity is actually worth on the day you hand it out. A 409A valuation figures that out for common stock, which is the kind founders and employees typically receive. It follows the rules in Section 409A of the Internal Revenue Code, added in 2005 in the aftermath of the Enron scandal, when regulators were cracking down on executives using equity to dodge taxes.
Get this wrong and the penalties land on your employees and shareholders, not just the company. So if you’re granting options, get the valuation done first.
Do You Need One?
If you’ve already granted equity or plan to, yes. The safest move is getting an independent 409A before issuing any common stock options. Early-stage companies benefit from this too because a properly done valuation lets you take advantage of IRS “safe harbors,” which shifts the burden of proof back to the IRS if they ever challenge your numbers.
When to Get One
You need a 409A valuation before your first stock option grants, after closing a venture financing round, annually (or sooner if something significant happens), and when you’re getting close to an IPO, merger, or acquisition.
How Long Does It Last?
Up to 12 months from the effective date, or until a material event happens. For most early-stage startups, a “qualified financing” event is the most common trigger. That usually means selling common shares, preferred equity, or convertible debt to outside institutional investors at a negotiated price.
What Counts as a Material Event?
Beyond a financing round, you probably need a new 409A if you land or lose a major contract that substantially changes your revenue, complete a significant acquisition on either side of the deal, receive a term sheet from a potential acquirer, form a strategic partnership likely to open new markets or improve profitability, or face regulatory changes that significantly expand or shrink your market.
If you’re not sure whether something counts, ask your 409A provider or legal counsel.
Understanding the Safe Harbor
When a 409A is done correctly, it qualifies for “safe harbor” status. That means the IRS presumes the valuation is valid unless it can prove the number was “grossly unreasonable.” There are three IRS-approved methods:
- Independent appraisal presumption
- Binding formula presumption
- Illiquid startup presumption
The independent appraisal route is by far the most common. A qualified third-party appraiser does the work, the valuation was done within 12 months of your option grant date, and nothing material changed between the valuation date and the grant. That combination gives you safe harbor.
The Three Valuation Methodologies
Independent appraisers use three main approaches, and they pick the one (or combination) that fits your company’s stage.
Market Approach (OPM Backsolve) — This is the go-to method when you’ve raised a funding round. The assumption is that your new investors paid fair market value, but since they got preferred stock, appraisers have to back out what the common stock is worth. You can also use financial data from comparable public companies to estimate your equity value.
Income Approach — For companies with real revenue and positive cash flow, this method values the business based on expected future cash flows, adjusted for risk.
Asset Approach — Used most often for pre-revenue companies without funding. It calculates the company’s net asset value to establish a baseline.
What It Costs
Widely variable. Standalone valuations run anywhere from $1,000 to over $10,000, depending on your company’s size and complexity. Some providers, including Syndicately, bundle it into an annual subscription alongside cap table management.
What’s a 409A Refresh?
After 12 months, or when a material event happens, you need an updated valuation. That update is called a refresh.
What You’ll Need to Provide
Once you’ve picked an appraiser, you’ll hand over a set of information about your business. Syndicately, for example, asks for:
Company Details
- CEO’s name
- External audit firm’s name (if applicable)
- Legal counsel’s name
- Amended and restated articles of incorporation
Industry Information
- Your industry
- A list of relevant comparable public companies
Fundraising and Options
- Anticipated timing of a liquidity event
- Company presentation, business plan, or executive summary
Company Financials
- Historical financial statements
- Revenue forecasts for the next 12 months
- EBITDA forecasts for the next 12 months
- Cash burn and runway
- Non-convertible debt amount
Additional Details
- Any significant events since your last 409A valuation (if this is your first, a complete history of relevant events)
The Penalties for Getting It Wrong
If your valuation falls outside the safe harbor, the consequences hit employees and shareholders directly:
- All deferred compensation from the current and prior years becomes immediately taxable
- Interest accrues on that revised taxable amount
- An extra 20% tax gets tacked on top of all deferred compensation
Most early-stage startups aren’t IRS audit targets, but that changes as you grow and move toward an exit. Getting this right from the start saves you from untangling a mess later.
How LLCs Handle It
LLCs work a bit differently. Instead of just issuing capital interests like common and preferred stock, stock options, and warrants, they can also issue profits interest units (PIUs). PIUs get assigned a liquidation threshold on their grant date, usually equal to the company’s equity value at that time. From that point forward, PIU holders participate in exit proceeds only for amounts above that threshold. That threshold is sometimes called the distribution threshold or hurdle threshold.
LLCs need to track the liquidation threshold for every grantee carefully so they can calculate what each person actually receives when a liquidity event happens.
