409A valuation

What is a 409A valuation?

A 409A valuation is an independent appraisal of a private company’s fair market value (FMV) that is used to set the exercise price for employee option grants. Named after section 409A of the U.S. Internal Revenue Code (IRC), it’s one of the primary methods used to value a private company. 

409A vs IFRS 13 valuations

409A and IFRS 13 valuations differ in terms of regulatory purposes and requirements. The type of valuation that a company needs depends on the accounting methodologies used in the country where it operates and where the company intends to issue equity awards.

For instance, private companies following U.S. Generally Accepted Accounting Principles (GAAP) use 409A valuations to determine the current FMV of their common stock. In other regions that follow International Financial Reporting Standards (IFRS), such as Asia-Pacific (APAC) and the Middle East (ME), IFRS 13 valuations are more commonly used to assess the fair value (FV) of company shares.

When do I need a 409A valuation?

If your company is based in the U.S. or has hired U.S. citizens, it’s likely that you’ll need a valid 409A valuation before issuing equity to these recipients.

For companies incorporated in the U.S., a valid 409A valuation is generally required:

• Before issuing common stock options to employees or advisors

• Before a liquidity event (i.e. an exit or dissolution) allowing shareholders to turn their equity into cash

• After any material event, such as a funding round

Early-stage startups may also need a 409A valuation to prevent shareholders from paying tax penalties that may otherwise be imposed by the IRS. A reputable 409A valuation provider can help you take advantage of safe harbors.

In APAC and ME, private companies may need both an IFRS 13 valuation—to comply with local accounting standards—and an independent 409A valuation if they plan to issue equity to U.S. tax residents.

What is a 409A material event?

The most common type of material event for early-stage startups is a financing round. This typically involves the sale of common shares, preferred equity, or convertible debt to independent, institutional investors at a negotiated price.

Outside of a financing round, a material event is any event or significant change that could affect a company’s stock price, including:

• A new or lost customer contract that represents a material change in revenue, including annual recurring revenue (ARR)

• Any material, closed acquisition in which your company is the buyer or seller

• When your company receives a term sheet from a potential acquirer or investor

• A strategic partnership that is likely to open new markets or improve margins

• Regulatory changes that significantly increase or decrease your addressable market

• A shift in the global economy

If you aren’t sure whether a recent event is considered material, reach out to a 409A valuation provider or consult your lawyer.

How long are 409A valuations valid?

409A valuations are valid for a maximum of 12 months after the effective date—or until another material event occurs. After 12 months (or sooner, if there’s a material event), your company will need an updated 409A valuation. Any event that may change your company’s valuation qualifies you for a new 409A.

What is IRC Section 409A?

Section 409A of the IRC contains the framework for private companies to follow when valuing private stock. If a company doesn’t adhere to 409A rules and its equity is priced incorrectly, the IRS can assess penalties.

What is a 409A safe harbor?

Generally, 409A valuations that have “safe harbor” status are presumed to be “reasonable” by the IRS. When a 409A valuation is conducted by an unaffiliated or independent party, it is eligible for “safe harbor” status.

The IRS provides three safe harbor methods for setting the FMV of private company’s common stock:

1. Independent appraisal presumption: This is the most common way to obtain safe harbor status and means you have an independent valuation from a qualified, third-party appraiser.

2. Binding formula presumption

3. Illiquid startup presumption

A 409A valuation is presumed reasonable if the stock was valued within 12 months of the applicable option grant date and no material change has occurred between the valuation date and the grant date.

409A penalties

When your 409A valuation isn’t performed using one of the IRS-approved methods listed above, it could fall outside of the 409A safe harbor. The penalties can be substantial for employees and shareholders:

• All deferred compensation from the current and preceding years becomes taxable immediately

• Accrued interest on the revised taxable amount

• An additional tax of 20% on all deferred compensation

Most startups aren’t likely to be audited by the IRS. That said, as your company grows and you approach an exit (such as a merger, acquisition, or IPO), it’s possible you could face IRS audits. You’ll save time and effort by working with a reputable valuation provider from the beginning.

Finding a 409A valuation provider

Hiring a reputable valuation firm to conduct your 409A valuation is key to achieving safe harbor status with the IRS. To meet the IRS’s requirements, a valuation provider should:

• Be a qualified, independent third-party appraiser with at least five years of relevant experience in business valuations or appraisals, financial accounting, investment banking, private equity, secured lending, or other comparable experience

• Have recent experience valuing similar private companies

• Use generally accepted valuation methods such as market approach, income approach, or asset approach

• Provide a detailed and comprehensive report

• Comply with IRS Section 409A guidelines

How much does a 409A valuation cost?

Some providers offer standalone 409A valuations, while others offer bundled services. For standalone valuations, the cost ranges anywhere from $1,000 to over $10,000 (USD), depending on the size and complexity of your company.

At Carta, 409A valuations are included in an annual subscription along with cap table management.

What do I need for a 409A valuation?

409As must be independent appraisals and cannot be done by the company itself. Appraisers try to determine what a company’s shares would sell for in an ideal market where buyers and sellers possess the same information about a company and its finances.

Once you’ve selected a 409A appraiser, you need to compile and share some important information about your business. As an example, Carta’s requirements are listed below.

Company details

• Name of your CEO

• Name of your external audit firm (if applicable)

• Name of your legal counsel

• Your amended and restated incorporation documents

Industry information

• Your industry

• A list of relevant and comparable public companies (most 409A valuations rely on some form of comparison to publicly traded companies)

Fundraising and options

• The most probable timing of a liquidity event

• Your company presentation, business plan, or executive summary

Company financials

• Historical financial statements

• Forecasted annual revenue for the next two calendar years, starting from the valuation date

• Forecasted annual EBITDA (earnings before interest, taxes, depreciation, and amortization) for the next two calendar years, starting from the valuation date

• Cash burn and runway

• Non-convertible debt amount

Additional details

Any materially relevant events since your last 409A valuation (if this is your first 409A, you should provide a complete history of relevant events)

409A valuation example

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

Common 409A valuation methodologies

A 409A valuation is based on guidance and standards established in section 409A of the IRC and independent appraisers have an obligation to ensure that your 409A and FMV is “fair.” To fulfill this obligation, appraisers consider factors such as a company’s current assets, its cash flows, comparable public companies, and the implied valuation from any recent secondary transactions.

There are three standard methodologies providers use during a 409A: market approach, income approach, and asset approach. 

1. Market approach (OPM backsolve)

When your company raises a financing round, valuation providers typically use the option pricing model (OPM) backsolve method. It can be safely assumed that new investors paid fair market value for the equity, but investors typically receive preferred stock instead of common stock. This method makes adjustments to determine the FMV for common stock.

Other market-based approaches use financial information like revenue, net income, and EBITDA from comparable public companies to estimate the company’s equity value.

2. Income approach

For businesses with sufficient revenue and positive cash flow, valuation providers often use the straightforward income approach. This method defines the value of the company based on its expected future cash flows, adjusted for risk.

3. Asset approach (cost approach)

The asset approach is often used for early-stage companies (pre-Series A) that haven’t raised money and don’t generate revenue. This methodology calculates a company’s net asset value to determine a proper valuation.

409A valuation vs. post-money valuation

There are two main types of valuations for private companies: a post-money valuation and a 409A valuation. Post-money valuations and 409A valuations can help you understand how much a private company is worth, but in different ways.

A 409A valuation:

• Is used to determine the FMV of a single share of a company’s common stock

• Sets the strike price for stock options issued to founders, employees, and advisors

• Is based on guidelines in the IRC

• Is typically determined by a third-party 409A valuation provider

• Protects employees from taxes and IRS fines (if done correctly)

A post-money valuation:

• Is determined by the price of preferred shares, which are more valuable than common stock

• Is based on how much investors paid for their ownership stake during a fundraising round

→ Learn more about pre-money vs. post-money valuations

How do LLCs handle valuations?

Limited liability companies (LLC), differ from corporations in their tax and equity structures, but they still generally require valuations to issue certain types of equity. Learn more about valuations for LLCs.

Carta’s 409A valuation process

Carta is trusted with over 15,000 audit-defensible 409A valuations each year, leveraging best-in-class software and industry expertise to deliver valuations faster and for less than traditional providers. Carta also offers liquidation threshold valuations for LLCs offering profits interest units alongside traditional 409A valuation services for corporations and other types of private companies. Reach out today if you have any questions or need a valuation. 

Download sample Carta 409A report

See what a complete 409A valuation report looks like.