What Is a 409A Valuation and How Does It Set Your Strike Price?
The strike price on a startup option grant comes from a 409A valuation. How the appraisal works, why it sits below the investors' price, and what a mistake costs.
A 409A valuation is an appraisal of the fair market value of a private company’s common stock, used to set the exercise price of employee stock options. Under IRS regulations, options priced at or above that value fall outside section 409A’s tax penalties. The board approves the value, and your grant notice shows the resulting strike price.
The name comes from section 409A of the Internal Revenue Code, which governs deferred compensation. The valuation rules are in Treasury Regulation 1.409A-1, checked as of November 2026.
Why does a startup need a 409A valuation?
A startup needs one because an option priced below fair market value on the grant date counts as deferred compensation under section 409A, and the employee then faces income tax plus penalties. An option whose exercise price is never less than the stock’s fair market value on the grant date is excluded from those rules.
A public company simply uses its trading price. A private company has no market price, so the regulation requires a “reasonable valuation method” that considers the company’s assets, projected cash flows, comparable companies, recent arm’s length sales of its stock, and discounts for lack of marketability. Incentive stock options carry the same requirement under the ISO rules: the option price cannot be less than fair market value at grant. Our explainer on ISO vs NSO stock options covers how each type is taxed.
What is the 409A safe harbor?
The safe harbor is a set of three valuation methods that the regulation presumes reasonable. If a company uses one, the IRS can overturn the value only by showing that the method or its application was “grossly unreasonable,” which shifts the burden onto the IRS.
| Safe harbor method | Main conditions |
|---|---|
| Independent appraisal | Meets the appraisal standards for ESOP valuations and is dated no more than 12 months before the grant |
| Formula price | Uses a formula that would set fair market value under a nonlapse restriction and is applied consistently whenever the company or a 10% holder buys or sells that class of stock |
| Illiquid start-up valuation | Company has run no trade or business for 10 years or more and has no publicly traded equity; written report by a qualified person; not available if a sale is reasonably expected within 90 days or an IPO within 180 days |
For the start-up method, the regulation says a qualified person generally has at least five years of relevant experience in business valuation, appraisal, financial accounting, investment banking, private equity, secured lending or similar work. Companies that want the strongest presumption typically hire an outside valuation firm under the first method. The full text is in 26 CFR 1.409A-1, paragraph (b)(5)(iv)(B).
How long is a 409A valuation good for?
A 409A valuation is good for at most 12 months, and less if something material happens first. The regulation says an earlier value stops being reasonable if it fails to reflect later information that may materially affect the company’s value, and gives the resolution of material litigation and the issuance of a patent as examples.
In practice, companies commonly order a new valuation after a priced funding round, a large change in revenue or outlook, a secondary sale of common stock, or the start of acquisition or IPO talks. The risk with an old valuation is simple: a price that was fair when the report was dated may be below fair market value on the day the options are granted.
Why is the 409A price lower than what investors paid?
The 409A price applies to common stock, while venture investors buy preferred stock with extra rights. Preferred shares usually carry a liquidation preference that pays investors back first in a sale, protective voting provisions and anti-dilution protection. Common stock has none of these and usually cannot be sold freely, so an appraiser applies a discount for lack of marketability.
That is why the common stock value can be well below the per-share price in the latest round. The round price itself is set on a different basis, explained in our guide to pre-money vs post-money valuation. As the company nears an IPO or sale, the gap tends to narrow because the preferences matter less and a market for the shares is closer.
How is a 409A valuation done?
- The company hires a valuation provider and supplies its cap table, financial statements, projections and the rights of each share class.
- The appraiser values the whole company using market, income or asset approaches, often anchored to the most recent arm’s length funding round.
- That value is allocated among the share classes, giving preferred stock credit for its preferences.
- A discount for lack of marketability is applied to the common stock.
- The board reviews the report, adopts the value and grants options at or above it.
What happens if options are priced below fair market value?
If an option is priced below fair market value and does not fit another exception, the penalties fall mainly on the employee. Under 26 U.S.C. 409A, the deferred amount becomes taxable as soon as it is no longer subject to a substantial risk of forfeiture, typically when the option vests, rather than at exercise.
- An additional tax of 20% of the amount included in income.
- Interest at the IRS underpayment rate plus 1 percentage point, calculated as if the income had been taxed when first deferred or first vested.
- Withholding and reporting obligations for the company.
Whether a mispriced grant can still be fixed, for example by raising the exercise price before it is exercised, depends on timing and IRS correction rules, which is a question for the company’s tax counsel.
What does a 409A valuation mean for you as an employee?
For an employee, the 409A value does three jobs: it sets your strike price, it sets the taxable spread when you exercise nonqualified options or calculate the alternative minimum tax on ISOs, and it sets the value used in an 83(b) election when you exercise early. Companies are not required to give employees the full report, but some will share the current per-share value if you ask HR or the equity administrator.
Bottom line
Check the grant date and the board-approval date on your option notice against the date of the most recent funding round. A grant made shortly after a large round, at a strike price set before it, is worth raising with the company, because a mispriced option is your tax problem as well as theirs. A tax professional can tell you whether the spread on exercise triggers income tax or AMT for you.
FAQ
Is the 409A value the price I can sell my shares for?
No. It is an appraisal for tax purposes. A buyer in a secondary sale or an acquirer may pay more or less, and many startups restrict sales of common stock altogether.
Does a company still need a 409A valuation after its IPO?
No. Once the stock is listed, fair market value is set by the trading price, and options are granted at the market price on the grant date.
Who pays the 409A penalties if the company got the valuation wrong?
The income inclusion, 20% additional tax and interest are imposed on the employee who received the option. The company can face penalties for failing to withhold and report, which is one reason companies use the safe harbor methods.
