409A valuation: when your startup needs a new one

A 409A valuation is an appraisal of your company's common stock, and you need one before you grant stock options, because an option priced below the stock's fair market value on the grant date falls under IRC §409A. Under the Treasury regulations, a valuation can support a grant for at most 12 months, and for less if something happens that may materially change what the stock is worth.

That something is usually a priced round. This guide covers what the valuation protects, the 12-month and material-information rules, the three ways to earn the IRS's presumption that your value is reasonable, a worked example with four grant dates, what goes wrong when a strike price is too low, and what to have ready before your next grant.

What a 409A valuation protects

A stock option is exempt from §409A only if its exercise price can never be less than the fair market value of the underlying stock on the date the option is granted (Treas. Reg. §1.409A-1(b)(5)(i)). For a private company there is no market price, so the 409A valuation is the evidence of what fair market value was on that date.

For stock that does not trade on an established market, the regulations require "the reasonable application of a reasonable valuation method." They list what a reasonable method considers: the company's tangible and intangible assets, the present value of its future cash flows, the value of comparable companies, recent arm's length sales of its stock, and discounts such as lack of marketability (§1.409A-1(b)(5)(iv)(B)(1)).

Founders often call this the common stock price. It is usually below the price investors paid for preferred stock, because preferred stock carries rights common stock does not. The appraiser's report explains the gap. Common stock that founders receive or employees get by exercising options can also be qualified small business stock, which decides how much of the gain on a sale escapes federal tax.

When a 409A valuation expires

A valuation stops supporting new grants in two cases. The regulations say a value is not reasonable if it was calculated for a date more than 12 months before the date it is used. It is also not reasonable if it fails to reflect information that became available afterward and may materially affect the value of the company (§1.409A-1(b)(5)(iv)(B)(1)).

The regulation's own examples of such information are the resolution of material litigation and the issuance of a patent. For a SaaS startup the common cases are a priced financing round, a term sheet for an acquisition, or a large change in revenue. A recent arm's length sale of the company's stock is one of the factors the regulations list, and a priced round is exactly that.

So "valid for 12 months" is a ceiling, not a promise. A valuation dated in January can be stale by April.

The three 409A safe harbors

Three valuation methods are presumed reasonable. Once you use one, the IRS can overturn the value only by showing that the method or how it was applied was "grossly unreasonable" (§1.409A-1(b)(5)(iv)(B)(2)). Without one, the value has to stand on the general facts-and-circumstances test alone.

The illiquid startup method has two conditions that catch people. The person doing it must have significant knowledge, experience, education or training, and significant experience "generally means at least five years of relevant experience" in valuation, financial accounting, investment banking or similar work. It also does not apply if, when you use it, you can reasonably expect a change in control within 90 days or a public offering within 180 days (§1.409A-1(b)(5)(iv)(B)(2)(iii)).

A worked example: one valuation, four grant dates

A startup gets an independent appraisal that values its common stock at $0.40 a share as of November 1, 2025. It closes a priced seed round on April 15, 2026. It gets a new appraisal at $0.90 a share as of May 20, 2026, and grants options on four dates.

The May grant is the one that goes wrong in practice. The valuation is only six months old, but it does not reflect a priced round that closed two weeks earlier, so a $0.40 strike price has no safe harbor behind it. The fix costs nothing but time: hold the grant until the new valuation lands, then price it at $0.90.

The July 2027 grant fails on age alone. Even if nothing changed, a valuation dated more than 12 months before the grant cannot support it.

What happens if the strike price is below fair market value

An option granted below fair market value is no longer exempt, and if it fails §409A, the option holder pays. Compensation deferred under it becomes includible in income once it is no longer subject to a substantial risk of forfeiture, usually when it vests. The income tax on it is increased by 20% of the amount included, plus interest at the underpayment rate plus 1 percentage point (IRC §409A(a)(1)).

Put in figures: on every $10,000 of compensation included in income this way, the additional tax is $2,000, before the regular income tax and the interest. The failure applies only to the participants it relates to, not to every holder in the plan.

That cost lands on your employees, which is why acquirers and investors check grant dates against valuation dates in diligence. Changing an option's terms afterward is treated as granting a new one (§1.409A-1(b)(5)(v)), so a correction needs counsel, and the sooner the better.

What your appraiser will ask for

A 409A appraiser starts from your financial statements, cap table and the terms of every round. Expect to send the latest balance sheet and income statement, your forecast, the preferred stock terms, and your revenue history. For a SaaS company the appraiser will ask about recurring revenue, so be clear which figure is which: the difference between ARR and recognized revenue is the first thing a careful one will ask about.

Expanding the option pool usually means authorizing more shares, and in Delaware more authorized shares can mean a much larger franchise tax bill under the default method. Plan the pool size and the valuation together, after a round, so the new grants and the new charter are priced on the same facts.

What to do before your next option grant

• Check the valuation date against the grant date. More than 12 months apart means you need a new valuation.
• Check what has happened since. A priced round, an acquisition offer or a large change in revenue means a new valuation before you grant, even inside 12 months.
• Record the valuation in the board approval for each grant, with its date and the price per share, so the strike price and its support sit in one place.
• Order the next valuation as the round closes, so it reflects the round and is ready when offer letters go out.
• Have counsel review any grant made on a stale or missing valuation, before the options vest.

Appraisers ask for current financial statements first. LedgerIt keeps your books closed each month, so the balance sheet and income statement for a new 409A are ready the week the round closes.