📄 409A Valuations

🎉 Happy Friday, funds family!

When a company grants stock options to service providers, it has to set a strike price. That’s the price at which employees can pay and exercise the options for shares.

Setting that price correctly is mandatory.

It's an important topic for companies and the investors who back them, because getting it wrong exposes employees and the company to material tax liability. The 409A valuation also shows up in every subsequent financing and acquisition diligence process.

A 409A valuation is an independent appraisal of the fair market value (FMV) of a company's common stock, required by the IRS before options can be granted.

Options must be granted at no less than FMV at the time of grant. If they are granted below FMV (whether intentional or not), the options fall outside the safe harbor of Section 409A of the Internal Revenue Code, which results in immediate income recognition and an additional 20% penalty tax on the employee. 👎️ 

That is a serious consequence that companies can avoid entirely by getting a proper valuation done before granting options.

➡️ Why does the IRS care about option strike prices?

Section 409A was enacted to prevent companies from granting discounted options as deferred compensation (a structure that allows employees to defer income recognition to a later, potentially more favorable, tax year).

The rule requires that stock options be granted at FMV at the time of grant. An independent third-party appraisal is the standard way to establish FMV and create a safe harbor against IRS challenge.

Without it, the company would be relying on its own informal assessment, which typically does not hold up in an audit.

➡️ How does a 409A valuation work?

A 409A valuation is performed by an independent third-party appraiser. Many firms specialize in startup valuations - we can refer you if interested.

The appraiser analyzes, among others:

• The company's financial condition, revenue, and projections.

• Recent arm's-length financings (e.g., SAFEs, convertible notes, priced rounds).

• Comparable public companies and transactions.

• The rights and preferences of the preferred stock versus the common stock.

⚠️ That last point is important. Because preferred stock has economic preferences over common stock (e.g., liquidation preferences, anti-dilution, etc.), the common stock in an early-stage company is worth meaningfully less than the preferred stock price in a financing. A credible 409A reflects this discount and updates it after each new financing.

A 409A is generally valid for 12 months or until a material event that would change the valuation (most commonly a new priced financing round). After any priced round, the company should promptly get a new 409A before granting additional stock options.

➡️ What is the relationship between the 409A value and the preferred stock price?

In early-stage companies, the FMV of common stock (as set by the 409A) is typically some fraction of the price paid for preferred stock. The ratio depends on the company's stage, but commonly ranges from:

• 10–25% of the preferred price at seed stage.

• 25–50% at Series A.

• 50–75% or higher at later stages.

As the company approaches a liquidity event, the common stock value converges toward the preferred stock price because the liquidation preference and other preferred economics become less meaningful relative to the overall company value.

➡️ Why do investors care about the 409A?

Investors care about the 409A for several reasons:

• If options have been granted below FMV, the company may have employees with significant latent tax liability. That’s a problem that can surface during diligence or post-close.

• The 409A value is used as a reference point for employee option grants, which affects the company's ability to attract and retain talent competitively.

• Acquirers and later-stage investors will review the 409A history as part of diligence. Therefore, gaps in coverage or stale valuations raise questions about the company's compliance posture.

• In any acquisition where options are being cashed out, the 409A history directly affects the tax treatment of option proceeds.

➡️ The practical takeaway

For the company:

1. Get a 409A valuation before granting any employee options—do not rely on an informal internal estimate.

2. Refresh the 409A annually or immediately following any material financing event, including new SAFE rounds.

3. Use a reputable, defensible appraiser; the cost is modest, and the protection is meaningful.

4. Track option grant dates relative to valuation dates; do not grant options while an updated 409A is pending.

For the investor:

1. Ask whether the company has current 409A coverage before every investment.

2. Review the ratio between the 409A strike price and the preferred stock price; a very low ratio relative to the company's stage may indicate aggressive option grant practices.

3. Include representations in financing documents confirming that all outstanding options were granted at or above FMV.

4. For portfolio companies preparing to make significant equity grants, flag the need for a fresh 409A before those grants are made.

Thanks for reading, everyone!

Have a great weekend, and happy Fourth of July! 🎉 

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This may be considered attorney advertising.