409A Valuation

A 409A valuation is an assessment of a private company’s common stock fair market value, often used when setting the exercise price for employee stock options.

What Is a 409A Valuation?

The 409A valuation meaning comes from Section 409A, which governs certain nonqualified deferred compensation arrangements. Private companies commonly obtain a valuation to support the fair market value used for stock option grants.

For certain nonstatutory options to fall outside Section 409A’s deferred compensation rules, the exercise price must be at least the fair market value of the underlying stock on the grant date, along with other requirements. The IRS discussion of stock option valuation explains specified valuation safe harbors.

How Does a 409A Valuation for Startups Work?

A valuation considers the company and the rights attached to its common stock. Relevant information can include financial results, forecasts, financing transactions, comparable businesses, and the company’s capital structure.

Common stock may have a different value from preferred shares sold in a financing round because the securities can carry different rights. A startup cannot simply assume its latest preferred share price is the value of its common stock.

The assessment supports a value as of a particular date. It does not predict what the company or its shares will sell for later.

Why Does the Grant Date Matter?

A company sets the exercise price when it grants an option. For 409A stock options, it needs support for the common stock’s fair market value at that time. A valuation can become outdated after a material event changes the company’s circumstances.

An option priced below fair market value can create Section 409A concerns if it does not otherwise comply with the rules. The consequences depend on the award’s design and facts. The IRS discussion of nondiscounted options describes relevant conditions.

What Should an Employee Review?

An employee evaluating an option grant should identify the number of options, exercise price, vesting schedule, expiration date, and type of option awarded. The current valuation is only one input.

It also helps to understand what happens after leaving the company, whether exercising requires a cash outlay, and whether any market exists for the shares. Private company shares may remain difficult to sell for years.

Frequently Asked Questions

Is a 409A Valuation the Company’s Sale Price?

No. It supports the fair market value of common stock for a specific purpose and date.

Is the Exercise Price Always the Latest Preferred Share Price?

No. Preferred and common shares can have different rights and values.

Does a 409A Valuation Guarantee an Employee Profit?

No. An option’s value to its holder depends on future outcomes and its terms.

ClairFi’s Clair360 can help place equity compensation within a wider picture of assets and financial goals.