Legal & Compliance
409A Valuation
An independent appraisal of a private company's fair market value of common stock, required by IRS rules to set the exercise price of employee stock options.
Section 409A of the IRS tax code requires stock options be granted at or above the fair market value of common stock at the time of grant. Companies commission third-party 409A valuations to establish this price.
409A valuations apply to common stock — always worth less than preferred stock because it lacks liquidation preferences and other investor rights. A company with a $100M preferred round valuation might have a 409A common valuation of $25-35M. Employees receive options at the lower common price.
409A valuations must be refreshed every 12 months or after material events like fundraising rounds.
In Practice
A startup raises a Series A at a $50M preferred valuation. The 409A values common stock at $15M. New employees receive options at a $0.15/share exercise price (based on $15M common value / 100M shares). This price is their cost to buy shares when they exercise — hopefully well below the future exit price.
Why It Matters
Granting options below the 409A fair market value triggers immediate ordinary income tax plus a 20% IRS penalty for employees — devastating consequences. Startups must maintain current 409A valuations and grant at or above the appraised price. For employees, the 409A price vs. the preferred round price reveals how much 'discount' their options represent.