A 409A valuation is an independent appraisal of a private company's common stock, used to set a legally defensible strike price for employee stock options. It's required under IRC Section 409A to protect option holders from punitive tax penalties.
Without a proper 409A, the IRS can treat options as deferred compensation, which triggers immediate taxation plus a 20% penalty for the employee holding them, a real cost that lands on the wrong person if the company skips this step. A 409A is generally valid for 12 months (365 days) from its effective date, or until a material event, a new funding round, for instance, makes the old valuation stale sooner.
Letting a 409A expire before granting new options is a quiet but common mistake. Nothing technically stops a company from issuing options against a lapsed valuation; it just exposes the recipient to real tax risk if it's ever examined. A valuation from 10 months ago has roughly 60 days left before it needs a refresh, which is about when most companies should already be lining up the next one.
Stock options have to be granted with a strike price at or above the fair market value of the common stock on the grant date. If the strike is too low, the option is treated as deferred compensation under Section 409A. For the employee, that means income tax on the spread as the option vests, an extra 20% federal tax, and interest, even if they never exercise.
A 409A valuation is how a private company proves its strike price was fair. A valuation by a qualified independent appraiser creates a safe harbor: the IRS has to show it was grossly unreasonable to challenge it.
A 409A is generally relied on for 12 months from its effective date, as long as nothing material changes. These events usually make it stale sooner, so a new one is needed before the next grant:
Common stock is usually valued below the price investors paid for preferred, because preferred carries rights common doesn't, like liquidation preferences. That gap is why options at a startup can be granted at a strike well under the last round's price.
Illustrative. Whether a past grant is actually exposed depends on the facts; a tax advisor can assess it.
Generally up to 12 months from its effective date, or until a material event such as a priced round, a significant change in the business, or an acquisition offer, whichever comes first.
Options with a strike price below fair market value are treated as deferred compensation. The employee can owe income tax on the spread as it vests, plus an additional 20% federal tax and interest.
Usually yes. A priced round is a material event, so the old valuation generally can't be relied on for grants made after it.
Investors buy preferred stock with rights like liquidation preferences. Options are for common stock, which doesn't have those rights, so it's typically worth less.
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