Software Growth

409A valuation

A 409A valuation is an independent appraisal of a private company's common stock, used in the US to set the exercise price of employee stock options.

A 409A valuation is an independent estimate of the fair market value (FMV) of your company's common stock. In the US you need one to set the strike price when you grant stock options to employees, advisors or contractors. The name comes from section 409A of the Internal Revenue Code, which taxes certain deferred compensation heavily when it is set up incorrectly.

Why it exists

If you grant options with a strike price below fair market value, the option can be treated as deferred compensation that breaks 409A. The consequences land on the holder: Carta summarizes them as immediate taxation of deferred compensation, interest, and an additional 20 percent tax. That is why companies buy a valuation rather than guess.

Safe harbor

Treasury regulations (26 CFR 1.409A-1(b)(5)(iv)(B)) say a valuation is presumed reasonable if it is made by an independent appraisal as of a date no more than 12 months before the grant. The IRS can only rebut that presumption by showing the method or its application was grossly unreasonable. The valuation also stops being reasonable if it ignores material information that arrives later. In practice that means:

  • Refresh it at least every 12 months.
  • Refresh it sooner after a material event, such as a funding round (priced, SAFE or convertible note), a big revenue jump, or an acquisition offer.

What goes into it

An appraiser looks at financials, growth, cash, comparable companies and recent transactions, then values the business and allocates value among the share classes. Because common stock sits behind preferred stock and its liquidation preference, the 409A price is usually well below the price investors paid. Cost and turnaround vary by provider, so get quotes. Once the report is in, your board must formally approve the new fair market value before you grant options at that price.

Do you need one?

Only if you grant options (or similar equity) to US taxpayers, wherever your company is incorporated. A solo founder who never grants equity does not. If you plan to hire with equity, get the valuation before the first grant, and keep each grant on your cap table with its vesting terms. Note that 409A is not the same as the price in a funding round, and it is not a figure to use when selling your company.

This is general information, not tax or legal advice. Talk to a qualified tax advisor.

Sources

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