What Is a 409A Valuation? (And Why It's Not What Your Shares Are Worth)

What is a 409A valuation?

A 409A valuation is an IRS-approved valuation of your company's common stock. It's named after Section 409A of the tax code, which requires private companies to value their common stock for tax purposes.

The primary purpose is to set the exercise price for stock options. The IRS says that if you're granted options, the exercise price must equal or exceed the fair market value (FMV) of the stock on the grant date. The 409A valuation is how companies determine that FMV.

If your company sets the exercise price below the 409A valuation, the IRS can treat you as having received compensation at grant, with tax consequences.

So every time a company grants options, it needs a recent 409A valuation to prove the exercise price is reasonable.

How 409A valuations are calculated

409A valuations are done by independent appraisers (usually valuation firms or accounting firms) using three standard methodologies:

1. The cost method. What did investors pay most recently? A company that just raised a Series B at $100M post-money might get a 409A of $70M - $85M, discounted from the most recent valuation.

2. The comparable companies method. Look at similar public company trading multiples and apply them to your company's metrics. This is more sophisticated and depends on finding truly comparable companies.

3. The discounted cash flow method. Project future cash flows and discount them back to present value. This requires a detailed financial model and projections.

Most companies use the cost method or comparable companies, because those are easier to defend to the IRS. The appraiser considers the company's stage, growth rate, market conditions, and recent funding rounds.

Why 409As are intentionally conservative

Here's the thing: 409A valuations are supposed to be conservative. They're designed to be defensible to IRS audit, not to reflect the true fair market value.

If a company gets audited and the IRS determines that the 409A valuation was too high (i.e., the stock was actually worth less), there's no tax penalty - it just means employees had less income tax due at grant. But if the IRS determines the 409A was too low (stock was actually worth more), then employees might owe back taxes plus penalties.

So companies and appraisers are incentivized to be conservative. A company that just raised Series B at $100M might take a 25-30% discount for the 409A, putting it at $70M-$75M. This discount accounts for illiquidity (you can't easily sell your shares), risk, and the fact that preferred shareholders have senior rights.

The gap between 409A and secondary market value

This is the critical issue: a 409A valuation is usually substantially lower than what your shares could actually sell for in the secondary market.

Why the gap? Because secondary investors have already accepted the illiquidity risk and are making a market price that reflects current conditions. The 409A is deliberately conservative to be IRS-defensible.

409A vs. headline valuation

Let's also distinguish between 409A and the headline company valuation (like "Series B at $200M valuation").

The headline valuation is what the most recent investors paid. It's usually higher than the 409A because headline valuations are set by supply and demand in the market, without the conservative bias the IRS requires.

The 409A is a deliberately conservative discount from the headline valuation, as a margin of safety for tax purposes.

So the hierarchy is: headline valuation (highest) > 409A (middle) > realistic secondary price (depends on market conditions, usually between the two or below 409A)

What determines your actual share value

Neither the 409A nor the headline valuation tells you what your shares are worth in a secondary transaction. What actually determines secondary market price:

• Cap stack and liquidation preferences (how much preferred shareholders get paid first)
• Recent company financial performance and growth rate
• Market conditions and investor appetite for secondaries
• Comparable transactions in similar companies
• Expected time to exit and exit scenarios

The 409A is just a tax number. It's not a market price. It's not even a realistic estimate of your share value. It's a conservative, defensible number for tax purposes.

Should you get a 409A valuation for personal planning?

No. You shouldn't use your company's 409A as your estimate of your equity value. Your company gets a 409A done to set exercise prices and keep the IRS happy. But for your personal financial planning, you need a more realistic number.

That's what price discovery is for. It's analyzing your cap stack, running waterfall scenarios, and pricing your shares based on recent secondary transactions - not based on a conservative, IRS-defensible valuation.

Key takeaway

409A valuations are IRS-compliant, conservative numbers used to set stock option exercise prices. They are not: - Your company's true valuation - The market price of your shares - What you should use to estimate your net worth

They're a tax requirement. For understanding what your equity is actually worth, you need a secondary market price based on real comparable transactions and your specific cap stack position.

This article is provided for informational purposes only and does not constitute investment, legal, or financial advice. The value of private company shares depends on many factors specific to each company and transaction. Earlyasset, Inc. is not a registered investment adviser. Consult qualified professionals before making any financial decisions involving private securities.