409A Valuations Explained: Why Every Startup Needs One
The valuation nobody negotiates but every company legally needs — and why it's deliberately lower than what investors just paid.
What a 409A valuation actually is
Section 409A of the tax code requires companies to determine the fair market value of their common stock when granting stock options, so that the strike price reflects a legally defensible, independent valuation rather than an arbitrary number. This protects both the company and option holders from tax penalties that can arise from options priced below fair market value.
Why 409A price is lower than the last funding round's price
Preferred stock carries more rights than common stock. Investors in a funding round typically receive preferred stock with liquidation preferences, anti-dilution protections, and other rights that common stock (the kind employees typically hold options over) doesn't have — a 409A valuation accounts for this difference, generally resulting in a lower per-share value for common stock than what preferred investors just paid.
This gap benefits employees, not just founders. A lower 409A strike price means employee stock options have room to appreciate in value even without an increase in the company's overall valuation, since employees are buying in at the (lower) common stock price rather than the preferred price.
When companies need a new 409A
Roughly every 12 months as a baseline. A 409A valuation is generally considered valid for up to 12 months, after which a new one is needed to continue issuing options at a defensible strike price.
After a new funding round. A new priced equity round is a material event that typically requires a fresh 409A valuation, since the company's value has likely changed meaningfully.
After other material events. Significant changes — an acquisition, a major new product launch, a significant change in financial performance — can also trigger the need for a new valuation, even within the standard 12-month window.
Why getting this wrong is expensive
IRS penalties for underpriced options. If options are found to have been issued below fair market value without a defensible 409A valuation, both the company and option holders can face significant tax penalties — this is a real, not theoretical, compliance risk.
Independent, professional appraisal matters. Because of these stakes, companies typically engage an independent valuation firm rather than setting the price internally, giving the valuation the independence needed to hold up to IRS scrutiny.
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Frequently Asked Questions
Who performs a 409A valuation?
Typically an independent third-party valuation firm, rather than the company itself, to ensure the valuation is defensible and independent for tax compliance purposes.
How long is a 409A valuation valid?
Generally up to 12 months, or until a material event (like a new funding round) occurs, whichever comes first.
Why is the 409A price lower than what investors paid in the funding round?
Because 409A valuations price common stock, which carries fewer rights and preferences than the preferred stock investors typically receive, resulting in a lower per-share value.
How does PitchProtocol help founders think about valuation and equity questions?
While PitchProtocol focuses on structuring your fundraising application, understanding concepts like 409A valuations helps founders navigate the broader equity and compensation decisions that come with raising capital. Apply to the First 100 Founders Cohort →