A 409A valuation is an independent assessment of your private company’s common stock fair market value, used to set the exercise price for stock options. You need one before you grant any options to employees or contractors, and the process involves hiring a qualified valuation firm, providing them with your company’s financial data, and receiving a report that establishes a defensible strike price. Here’s how the process works from start to finish.
Why a 409A Valuation Matters
Section 409A of the Internal Revenue Code requires that stock options be granted at or above fair market value. If you set the exercise price too low, your employees face serious tax consequences: the IRS can treat the deferred compensation as immediately taxable income, plus a 20% additional tax penalty on top of regular income taxes. That penalty hits the employee, not the company, but granting underpriced options also creates legal liability for your startup.
To protect both sides, the IRS created a “safe harbor” system. If your valuation meets certain conditions, the IRS presumes it’s reasonable and can only challenge it by proving the valuation was “grossly unreasonable,” a high bar. The most common safe harbor is getting an independent appraisal from a qualified firm. For startups with illiquid stock, the IRS also allows a valuation performed by a person with “significant experience,” which the regulations define as at least five years of relevant work in business valuation, financial accounting, investment banking, private equity, or a comparable field.
When You Need One
You need your first 409A valuation before granting any stock options. After that, the valuation must be updated at least every 12 months. You’ll also need a new valuation after any material event that could change your company’s value, even if it’s been less than a year. The most common triggers include closing a new funding round, completing a secondary sale of shares, a significant pivot in your business model, a major customer win or loss, or any event that meaningfully shifts your company’s financial outlook.
If you’re planning a change in control (like an acquisition) within the next 90 days, or an IPO within the next 180 days, the startup safe harbor no longer applies. At that point, you’ll need a standard independent appraisal rather than relying on the more flexible startup presumption.
Documents to Prepare
Before engaging a valuation provider, gather these materials:
- Financial statements: Current and historical income statements, balance sheets, and cash flow statements
- Capitalization table: A complete cap table showing all classes of stock, options, warrants, convertible notes, and SAFEs
- Funding round details: Term sheets and stock purchase agreements from recent rounds
- Business projections: Your pitch deck, business model overview, and 12 to 24 months of financial projections
- Other relevant details: Major contracts, intellectual property documentation, and notes on any significant business events since your last valuation
The more organized this information is, the faster the process goes. Most valuation firms will send you a data request checklist after you engage them, but having these materials ready upfront can shave days or weeks off the timeline.
How the Valuation Firm Sets the Price
The valuation process has two main steps. First, the firm determines your company’s total enterprise value. Then it allocates that value across different classes of stock to arrive at a per-share price for common stock.
For enterprise value, the firm typically uses a combination of approaches: comparing your company to similar public or recently acquired companies (a market approach), analyzing your projected cash flows (an income approach), or looking at your most recent funding round as a data point (a backsolve approach). Early-stage startups with little revenue often rely heavily on the most recent round price as an anchor.
Allocating Value to Common Stock
Once the firm has an enterprise value, it needs to figure out what share of that value belongs to common stockholders versus preferred stockholders. Preferred shares have liquidation preferences and other rights that make them more valuable, so common stock is always worth less than the last round’s preferred price. Three methods are commonly used for this allocation:
- Option Pricing Method (OPM): Treats each class of stock as a call option on the company’s total equity value. The “exercise prices” are based on the liquidation preferences of preferred shares. OPM works well for early-stage companies where future outcomes are highly uncertain, because it doesn’t require you to predict specific exit scenarios.
- Probability Weighted Expected Return Method (PWERM): Models specific future outcomes for the company (IPO at a certain valuation, acquisition, staying private, shutting down) and assigns a probability to each. It then calculates what common stock would be worth under each scenario and produces a weighted average. PWERM is more common for later-stage companies closer to a liquidity event.
- Hybrid Method: Combines elements of both. It uses probability-weighted scenarios like PWERM but applies OPM to allocate value within at least one of those scenarios. This is increasingly popular for companies between early and late stages.
The firm also applies a discount for lack of marketability (DLOM), reflecting the fact that private company shares can’t be easily sold on an open market. This discount typically reduces the common stock value by 20% to 35%, though it varies based on how close the company might be to a liquidity event.
What the Process Looks Like
After you select a provider and submit your documents, expect a kickoff call where the valuation analyst asks questions about your business, recent developments, and growth trajectory. They’ll want to understand not just the numbers but the story behind them: why revenue grew or declined, what your competitive landscape looks like, and what milestones you’re targeting.
The analyst then builds their valuation model, selects comparable companies, and drafts a report. Most firms deliver a preliminary valuation for your review before finalizing. This is your chance to flag any factual errors or provide additional context. The full process from engagement to final report typically takes two to four weeks, though some providers offer expedited turnaround for an additional fee.
The final deliverable is a formal valuation report, usually 30 to 60 pages, that documents the methodologies used, assumptions made, and conclusions reached. This report is what you’d present if the IRS ever questioned your option pricing or if your auditors need to review your equity compensation practices.
Costs by Company Stage
409A valuations typically cost between $2,000 and $5,000 or more, depending on your company’s complexity. Seed-stage companies with simple cap tables and no revenue can expect to pay on the lower end, while Series B and C companies with multiple funding rounds, complex capital structures, and international operations will pay more.
Some cap table software vendors offer bundled or “free” 409A valuations as part of their platform. These can be convenient, but they sometimes rely heavily on templates without adjusting for your company’s unique circumstances. An independent valuation provider with flexibility to account for your specific situation generally produces a more defensible result.
When choosing a provider, prioritize firms that have experience with companies at your stage and in your industry. The report should be audit-ready, meaning your external auditors will accept it without pushback. Ask whether the provider will support you if the IRS or your auditors have follow-up questions, and make sure the report includes clear explanations of how the valuation was reached rather than just a final number.
Setting Your Option Strike Price
Once you receive your 409A valuation report, the fair market value it establishes becomes the floor for your option exercise price. You can set the strike price at or above that number, but never below it. Your board of directors formally approves the grant at the price supported by the valuation.
Keep in mind that the valuation reflects a point in time. If you wait several months after receiving the report and something material changes in your business, you may need an updated valuation before granting new options. Granting options promptly after receiving a fresh 409A report is the cleanest approach. Many startups build a regular cadence, getting a new valuation annually or right after each funding round, and then batching their option grants shortly after.