409A valuation
The independent fair-market-value appraisal that sets the option strike price under IRC Section 409A.
| Statute | Internal Revenue Code § 409A and Treas. Reg. § 1.409A-1(b)(5) |
|---|---|
| Refresh interval | Every 12 months, or on a material event (financing, secondary, M&A discussions) |
| Penalty if not compliant | Immediate income tax on vested in-the-money amount plus a 20 percent additional tax under § 409A(a)(1)(B) |
| Applies to | US corporations granting options, and non-US corporations granting options to US taxpayers |
Why 409A exists
Internal Revenue Code Section 409A was enacted in 2004 as part of the American Jobs Creation Act, in response to perceived abuses around deferred compensation. Section 409A taxes deferred compensation that fails to meet specific requirements: the income is included in the recipient's gross income at the moment of vesting, plus an additional 20 percent federal tax, plus interest. Stock options issued at a strike price below fair market value are treated as deferred compensation under Section 409A, so the penalty applies to every vesting tranche.
The 409A valuation is the mechanism by which a corporation establishes the fair market value of its common stock for option-pricing purposes, so that options can be granted at or above that value and escape the deferred-compensation classification. A compliant 409A valuation creates a presumption of reasonableness that the IRS can rebut only by showing the valuation was grossly unreasonable.
The safe-harbor methods
Treasury Regulation § 1.409A-1(b)(5)(iv)(B) provides three safe-harbor methods for setting fair market value:
- Independent appraisal. A written appraisal by a qualified appraiser, reflecting an arms-length valuation method consistent with general business-appraisal standards. This is the method used by almost every option-granting corporation.
- Illiquid-startup safe harbor. Available to corporations less than 10 years old that have not anticipated a change of control or IPO within the next 90 days. Requires a written valuation by a person with significant knowledge and experience or training in the relevant valuation work.
- Generally applicable repurchase formula. A pre-established formula used consistently for both compensatory and non-compensatory transactions in the corporation's stock.
The first method, third-party appraisal, is the standard. A typical 409A report runs 30 to 80 pages and includes a corporate background, financial history, comparable-company analysis, discounted cash flow analysis (where the business is revenue-producing), option-pricing-method allocation across share classes, and a marketability and minority-interest discount.
When a refresh is required
A 409A valuation is presumed reasonable for 12 months from the date of the report. If the corporation grants options more than 12 months after the last 409A, the safe-harbor protection is lost on those grants. A new 409A must be obtained before granting again.
A material event can shorten the 12-month window. The most common material events:
- Closing a priced equity round (the new preferred price re-anchors the common-stock value)
- Closing a meaningful secondary transaction in the corporation's stock
- Beginning serious M&A or IPO discussions
- Material changes in the business: large customer wins or losses, regulatory approvals, key-employee transitions
The conservative practice is to refresh the 409A immediately after a priced round, then issue a batch of new grants at the refreshed strike price.
Practical workflow
The 409A workflow for an option-granting corporation:
- Engage a 409A provider. Specialist providers price around $1,500 to $5,000 per valuation; cap-table platforms often bundle 409As at lower per-valuation cost.
- Provide financial statements, cap table, recent financing terms, and management forecasts.
- Receive the draft report, review for factual accuracy, and request the final report.
- The board adopts a resolution setting the strike price for the next batch of grants at the 409A common-stock value.
- Each grant is documented at the adopted strike price. The 409A report is filed in the minute book under the resolution that adopted it.
- Repeat annually, or on any material event.
The 409A report itself is not filed with the IRS. The corporation retains the report and produces it on examination if the IRS challenges any option grant.
Octelligence stores the 409A report as a first-class object alongside the board resolution that adopts its common-stock value. Each option grant references the 409A under which it was priced, so the audit trail from the 409A through the board resolution to the grant notice is one click long.
See Cap Tables & FinancingStore the 409A alongside the board resolution that adopts it, and link every option grant to the 409A under which its strike was set.