What Is a 409A Valuation?

A 409A valuation is an independent appraisal of a private company’s common stock, performed to establish its fair market value for tax purposes — most importantly, to set the strike price of employee stock options. Named for Section 409A of the U.S. Internal Revenue Code, it’s the reason a startup can grant options priced at, say, $2 per share while investors are simultaneously paying $20 per share for preferred stock in the same company.

Why the strike price matters

When a company grants stock options, the strike price — what an employee pays to exercise each option — is typically set at the stock’s fair market value on the grant date. Set it too low relative to the real value, and the IRS can treat the options as deferred compensation, triggering immediate taxation and penalties for the employee well before they’ve actually sold anything. Set it accurately and defensibly, and the company gets a safe harbor: as long as the valuation follows an IRS-recognized method and is performed by a qualified, independent party, the burden of proof shifts to the IRS to show the valuation was materially wrong, rather than the company having to prove it was right.

That safe harbor is why 409A valuations exist as a formal, recurring process rather than something a founder just estimates internally.

Why common stock is priced below preferred

A 409A valuation almost always values common stock — what employees hold — well below what investors just paid for preferred stock in the company’s latest funding round. That gap isn’t a discrepancy; it reflects real differences in what the two classes of stock actually get:

• Liquidation preference. Preferred shareholders are typically paid back before common shareholders in an acquisition or wind-down, often with a guaranteed multiple on their investment. That downside protection has value that common stock doesn’t share.
• Lack of marketability. Common stock in a private company can’t be freely sold on an exchange, and appraisers apply a discount — often 15–30% — to reflect that illiquidity.
• Additional preferred rights. Board seats, anti-dilution protection, and other negotiated terms further separate what preferred investors are paying for from what a common shareholder holds.

A funding round that values the company’s preferred stock at $20 a share might reasonably produce a 409A common valuation of $6–10 a share once these factors are priced in — which is exactly why a fresh round of funding is one of the most common triggers for a new 409A.

When companies get a new valuation

A 409A valuation isn’t a one-time event. It’s typically refreshed:

• Every 12 months, as a baseline requirement to keep the safe harbor valid.
• After any new funding round, since a new price for preferred stock changes the inputs the appraisal relies on.
• Following a material change in the business — a large acquisition, a significant revenue shift, or other developments an appraiser would reasonably expect to move the valuation.

An outdated 409A stops providing safe harbor protection, which is why fast-growing startups sometimes refresh theirs more often than once a year.

How the valuation is calculated

Independent valuation firms typically combine three approaches, weighting them based on the company’s stage:

1. Market approach — comparing the company to similar public and recently-acquired private companies, often anchored to the price of the most recent funding round.
2. Income approach — projecting future cash flows and discounting them to present value, more relevant for companies with established revenue.
3. Asset approach — valuing the company based on its net assets, mostly relevant for very early-stage companies with little revenue history to project from.

The output allocates a fair market value across each class of stock the company has issued, reflecting the different rights and preferences of each — the same kind of structure detailed on a company’s cap table.

How this connects to equity compensation

A 409A valuation is the number that makes an option grant’s eventual payoff calculable: the difference between the strike price set at grant and the share price if the company is later acquired or goes public is the option’s value. It also directly affects equity dilution calculations and interacts with vesting schedules, since an employee’s options only become exercisable — at that fixed strike price — as they vest over time. Some early-stage companies also use SAFE agreements for investor fundraising specifically because they don’t convert into priced equity until a later round, deferring the need for some 409A complexity until that round happens.

The takeaway

A 409A valuation is an independent, IRS-recognized appraisal that sets the fair market value of a private company’s common stock, primarily to price employee stock options defensibly. It’s almost always lower than what investors just paid for preferred stock, because common stock lacks the liquidation preference, marketability, and other rights baked into preferred terms — and it needs refreshing at least annually, or sooner after a funding round, to keep its safe-harbor protection intact.