A founder’s guide to the 409A valuation

Author:
Kristoffer Warren

Learn everything you need to know about 409A valuations including what they are, when you need a valuation, valuation methodologies, and the full process.

Contents

• What is a 409A valuation?
• Why your startup needs a 409A valuation
• When to get a 409A valuation
• What qualifies as a 409A material event?
• How long is a 409A valuation valid?
• Understanding IRC Section 409A and its penalties
• What is 409A safe harbor?
• 409A penalties
• How is a 409A valuation calculated?
• The 409A valuation process
• 409A valuation example
• How to choose a 409A provider
• How much does a 409A valuation cost?
• 409A valuation vs. fundraising valuation
• Common 409A myths and mistakes
• How Carta simplifies 409A valuations
• Frequently asked questions about 409A valuations

What is a 409A valuation?

A 409A valuation is an independent appraisal of the fair market value (FMV) of a private company’s common stock. Its main purpose is to determine the minimum strike price for stock options. If your company plans to issue equity to employees, advisors, or other service providers, you’ll generally need a 409A valuation to remain in compliance with Section 409A of the U.S. Internal Revenue Code (IRC).

Why your startup needs a 409A valuation

A 409A valuation is a mark of professionalism that builds trust with investors. A history of regular, defensible valuations shows that you are organized and take compliance seriously.

When to get a 409A valuation

You should plan to get a valuation at several key moments in your company’s journey:

• Before you issue your first stock options to employees or advisors.
• After a material event occurs that could change your company’s value.
• At least once every 12 months to maintain compliance.

What qualifies as a 409A material event?

A material event is any significant business change that could reasonably affect your company's stock price.

Common examples of material events include:

• You close a new financing round.
• You receive a credible term sheet offer to be acquired by another company.
• Your financial projections change.

How long is a 409A valuation valid?

A 409A valuation is valid for a maximum of 12 months from its effective date. Its validity ends sooner if a material event occurs.

Understanding IRC Section 409A and its penalties

The IRS introduced Section 409A in 2005. Its goal is to prevent companies from issuing stock options at an artificially low price. The consequences of non-compliance fall heavily on your employees, who could face tax penalties on their vested options if the IRS determines your strike price was too low.

What is 409A safe harbor?

An independent 409A valuation establishes a “safe harbor” status with the IRS, providing a presumption of reasonableness for the valuation and protecting companies from penalties.

409A penalties

If your 409A valuation isn’t performed using one of the IRS-approved methods, significant penalties can apply for employees and shareholders.

How is a 409A valuation calculated?

There are three methodologies commonly used during a 409A:

1. Market approach (OPM backsolve)
2. Income approach
3. Asset approach (cost approach)

The 409A valuation process

The process typically involves three main steps:

1. Gather your documents.
2. Kick off with your provider.
3. Review the draft report.

409A valuation example

To see what a complete 409A valuation report should look like, download the sample report below:

How to choose a 409A provider

Choosing a provider of 409A valuation services requires finding a long-term partner who understands the startup journey.

How much does a 409A valuation cost?

The cost of a 409A valuation can vary. Traditional valuation firms often charge a significant one-time fee.

409A valuation vs. fundraising valuation

The difference between a 409A valuation and a fundraising valuation lies in their purposes:

Common 409A myths and mistakes

Understanding common myths about 409A valuations can help avoid costly mistakes.

Myth: The lower the strike price, the better.
Reality: An artificially low strike price is a red flag for auditors.

How Carta simplifies 409A valuations

At Carta, we've integrated valuations directly into our equity management platform to make the process simple and accurate.

Frequently asked questions about 409A valuations

• Is a lower 409A valuation always better? No, an accurate and defensible valuation is always better.

• Can I do my own 409A valuation? No, you need a qualified, independent appraiser to ensure compliance.

• What happens if my 409A valuation is too high or too low? A valuation that is too low can trigger tax penalties, while a high valuation can make equity grants less attractive.

• When should my company get its first 409A valuation? Before issuing stock options for the first time.

Author: Kristoffer Warren
Kristoffer Warren has been at Carta since 2017 and has extensive experience in finance.