From Eqvista: Understanding 409A Valuations

Why a 409A Valuation Is Necessary Before Issuing Options

Section 409A of the Internal Revenue Code requires that stock options be granted at an exercise price at or above fair market value. If you grant options below that price -even unintentionally- employees face serious tax consequences the moment those options vest.

And your company will likely face serious consequences as well. Employees who discover they're on the hook for unexpected taxes, penalties, and interest often look to the company for answers and compensation. What was meant to be a retention tool becomes a source of resentment, legal exposure, and potential liability.

But how do you prove your valuation was correct in the first place? That's where the safe harbor provision comes in.

A valuation that qualifies for safe harbor is presumed reasonable. If the IRS wants to challenge it, they must prove it was "grossly unreasonable", which is a high bar. Without safe harbor, the burden flips. The company must defend its valuation, often years later, under audit pressure, with limited documentation.

There are three ways to obtain safe harbor protection:

1. Independent appraisal - A valuation performed by a qualified professional with significant knowledge and experience in the relevant industry
2. Startup safe harbor - A good-faith valuation by a company less than 10 years old with no readily tradeable stock, using reasonable methods and documented in writing
3. Binding formula - A formula used consistently for all compensatory and non-compensatory transactions involving the same class of stock

For most startups beyond the earliest stages, an independent 409A valuation is the clearest path to safe harbor protection - and the focus of this article.

Explaining 409A Valuation

A 409A valuation is an independent assessment that ascertains the fair market value (FMV) of a private company’s common stock. It is primarily used for pricing stock options, though valuation is also relevant to other forms of equity compensation. In easier terms, you can think of it as your company’s official price tag for employee stock options.

Why You Can’t Just “Guess” Fair Market Value

Employee stock options must be priced at the fair market value of common stock. But what is that, exactly? For private companies, it's not as simple as looking up a stock price. There is no ticker, no daily market-clearing price, and no transparent valuation for common shares. Unless the company is very early-stage, it’s difficult to determine the correct value.

The Valuation Discounts Most Founders Miss

Two key discounts come into play when determining the fair market value of common stock and most founders miss at least one of them.

The Discount for Lack of Marketability (DLOM)

Private company shares can't be easily sold. There's no public market, no ticker symbol, no liquidity. An employee holding options in a private startup can't simply log into a brokerage account and cash out.

This illiquidity reduces value. A share you can sell tomorrow is worth more than an identical share you might be able to sell in five years, subject to company approval, transfer restrictions, and right of first refusal provisions.

DLOM typically ranges from 10% to 35%, depending on factors like:

• Expected time to liquidity - The longer the likely hold period, the higher the discount
• Transfer restrictions - Lockup provisions, rights of first refusal, and board consent requirements all increase the discount
• Company stage - Earlier-stage companies with uncertain paths to exit warrant higher discounts
• Likelihood of an IPO or acquisition - A company in active M&A discussions may have a lower discount than one with no exit on the horizon

The Preferred vs. Common Stock Discount

After a financing round, preferred shares carry rights that common stock lacks such as liquidation preferences, downside protection, anti-dilution provisions, and often board seats or consent rights. Common stock has none of these.

As a result, common stock is often valued at a meaningful discount to the preferred price - commonly 20–40% at early stages.

Why This Matters

Without rigorous valuation methodology that accounts for both discounts, founders face two risks:

1. Strike price too low → IRS penalties, loss of safe harbor, employee tax exposure
2. Strike price too high → Options become unattractive, undermining retention and recruiting

A 409A valuation exists to solve this exact problem.

When a 409A Valuation Is Required

Knowing when to get a 409A valuation is just as important as getting one. Here's what triggers the initial requirement - and what requires an update.

Initial Triggers

• First stock options: Issuing stock options for the first time to employees, contractors, or advisors requires an immediate 409A valuation to establish the strike price.
• Stock Appreciation Rights (SARs): If you're granting SARs that will be settled in stock or cash based on stock value, you need a current valuation.
• Hiring key executives with equity: Bringing on a CEO, CFO, or other senior hire with a significant equity component often accelerates the need for a valuation if one has not yet been done.

Update Requirements

409A valuations don't last forever. They must be updated:

• At least once every 12 months, or
• Earlier, if a material event occurs

Material Events Requiring Early Updates

Any of these events may require an updated valuation:

• New fundraising rounds: Closing a priced equity financing round
• Significant revenue changes: Major growth or decline in business performance
• Acquisitions or M&A Talks: Being acquired or acquisition discussions
• Secondary transactions :Employee stock sales or secondary market activity
• Major model shifts: Major pivots or changes in company direction
• Market Outlook Changes:Significant industry or competitive landscape shifts

The valuation ensures that equity grants remain defensible as the company evolves.

Don’t let Poor Compliance Derail Your Business

A 409A valuation is a structural requirement that protects employees, founders, and the company itself. Without it, founders may have difficulty selling their business, and employees may unknowingly assume significant tax risk, turning what should be a long-term wealth-building opportunity into an unexpected financial liability.

Getting it right ensures that equity does what it is meant to do: align, reward, and endure.

Through its platform, Eqvista has, as of December 2025, supported over 23,000 companies, completed 1,500+ valuations as a leading 409A valuation provider, and delivered $270B+ in valuation insights.