409A valuations are crucial because they provide insight into a startup's value. They protect companies and employees from tax-associated risks while ensuring equity compensation is priced fairly and backed by a legitimate process.
Below, we’ll explore why 409A valuations exist, how they differ from fair market value, and what they really mean for your equity.
A 409A valuation is a formal assessment used to establish the fair market value of a private company’s common shares. The method and its mandates are becoming increasingly important as companies stay private longer. Many late-stage startups delay IPOs, making accurate 409A valuations even more critical for employee equity and investor confidence.
That’s because a 409A valuation is required before startups offer equity, such as stock options, to their employees and other stakeholders. Other situations can require a 409A valuation, too. Here’s how to use this important value mechanism.
409A valuations are crucial for companies that grant stock options to employees, consultants, directors, and others, as they ensure equity compensation is priced fairly. They’re also required by law.
It was introduced as part of the American Jobs Creation Act, partly in response to the Enron scandal, in which the corporation used deferred compensation to pay executives even as the company was failing. The name comes from Section 409A of the U.S. tax code, which outlines the regulations governing things like equity, such as stock options and restricted stock units.
A 409A valuation is required before offering any type of equity, including stock options. What your stock options are really worth matters more than most employees realize—especially when it’s tied to your strike price, tax bill, and long-term upside. It must be updated annually or whenever a significant event occurs that could affect the company’s value—like a new funding round or a change in capitalization.
One of the most likely reasons for needing a new 409A valuation is a merger, acquisition, or IPO. The mechanism protects shareholders from certain tax penalties and helps ensure safe harbor status with the IRS, safeguarding companies from stock option pricing penalties.
For this status to be achieved, the stock should be valued within 12 months of the applicable option grant date. Significant changes between the valuation and grant dates could lead the IRS to deem the valuation “grossly unreasonable.”
The fair market value (FMV) of a stock reflects the price of a single share on the open market. As such, the stock market tells us the price of shares for public companies. Publicly available information, such as company earnings and market conditions, influences this value.
For private enterprises, it is more complicated. A 409A valuation is the primary IRS-accepted method to determine the current fair market value of a private company’s common stock. They will often be carried out by a third party.
Appraisers use different methods to estimate the value of a private company, often depending on what stage the startup is at. The value of assets, the present value of future cash flows and the value of stock at similar companies could all be factors in defining the FMV.
409As are used to price stock options, a key part of how startups reward early employees for taking on the risk of joining an unproven company. These serve as a powerful tool to attract top talent, offering a stake in the company’s future success and aligning employee incentives with long-term growth.
A 409A valuation is important for employees because it determines the strike price — the cost of a single share when exercising stock options. It can also impact taxes, as taxes on options are calculated using the 409A valuation.
The 409A valuation of a private company is comparable to the price of a public firm’s stock. That's particularly useful given that private secondary market platforms, like the one created by Augment Capital*, are growing in popularity. It's a bit like the stock market, but for private companies.
Augment helps investors make sense of equity and 409A impacts by offering a private stock marketplace where stakes in those companies can be sold. That makes it crucial to know the fair market value of pre-IPO companies.
It makes it easier for qualified individuals and smaller institutions, such as pensions and endowments, to access top pre-IPO companies. This “closer-to-the-finish-line” strategy gives buyers visibility into more mature companies, reducing risk and 409A volatility. These opportunities were once limited to private equity and venture capital firms due to high investment minimums.
By providing real-time pricing data and insights into the private market, Augment has established more transparency in the private market. The pre-IPO investment platform enables stakeholders to stay informed about potential transactions, as well as the effects they may have on their equity and 409A valuation.
*Securities transactions are executed on Augment Capital, LLC's ATS and offered through Augment Capital, LLC (member FINRA/SIPC).
Important Disclosures: Investing in private securities involves substantial risk, including the potential loss of principal. Private securities are typically illiquid, have limited pricing transparency, and often require longer holding periods. These investments are available exclusively to qualified accredited investors and offer no guarantee of returns. Additionally, past performance of private securities does not indicate or predict future results.