409A valuation, explained

A 409A valuation is an appraisal of what one share of your common stock is worth. It's named after Section 409A of the tax code, which can impose extra tax and penalties on deferred compensation that doesn't follow its rules. An option whose exercise price is below the stock's fair market value on the grant date can fall into that.

So before granting options, you find out what common stock is worth and set the exercise price, also called the strike price, at or above it.

Most startups hire an independent valuation firm. It looks at your financials, your latest financing and comparable companies, then splits the company's value between preferred and common. Common usually comes out lower than what investors paid for preferred, because preferred carries rights like a liquidation preference.

Under the Treasury regulations, an independent appraisal dated no more than twelve months before the grant is presumed reasonable. The IRS can overcome that only by showing the valuation was grossly unreasonable. Refresh it at least every twelve months, and after a priced round or another material event.

The regulations offer two other presumptions. A company under ten years old with no traded stock and no sale or IPO in sight can rely on a written valuation by someone with significant relevant experience. A binding formula price used for all transfers also qualifies, though startups rarely use it.

Acme raises a seed round at $2.00 per share of preferred. Its 409A, dated a month later, values common at $0.60, and the board approves option grants at $0.60, citing the report. Ten months later Acme closes a Series A. The old report no longer reflects the company, so Acme orders a new 409A before the next grant.

The same value usually feeds the option-pricing model for stock comp under ASC 718. In diligence, investors check that every grant on the cap table had a current 409A behind it.