What is a 409A valuation, and how does it affect stock options?

409A Valuation (Fair Market Value): What It Means for Startup Employees

The 409A valuation, also known as fair market value or simply the 409A, is a company share appraisal used for tax purposes. For startup employees with stock options, understanding the 409A is essential: it determines the taxes you owe when exercising options and influences your strike price. When paying taxes on your equity compensation, the amount you owe is based on the 409A.

Your employer is required to have the 409A valuation reassessed by a third party at least once a year — or when something impactful happens, like a new funding round.

The 409A reflects company growth. Is the company in a better place than last time? Then the 409A will rise. And the faster the company is growing, the higher the increase.

When you exercise your ISOs or NSOs, the tax bill you trigger depends on the current 409A valuation. So while an increasing 409A is a good sign for the company, it’s bad for your tax situation if you haven’t yet exercised.

If you have stock options and want to get the full picture of how they work, read our Stock Option Starter Guide.

How to find your company’s current 409A valuation?

Ask your employer for the current 409A.

How is the 409A valuation determined?

The 409A is determined by an independent valuation provider.

Every company that offers equity to their employees is required to get a 409A valuation. Re-valuations are required at least yearly, or whenever there is a material event (such as a new investment round) that may impact the company’s valuation.

Generally speaking, as your company grows more successful, the 409A increases.

The independent valuator determines the 409A using one of several approaches. They may analyze comparable private and public companies, analyze the company’s free cash flow or take the company’s tangible and intangible assets as the basis for their valuation.

How do I know when the 409A will change?

An upcoming 409A change is important to know because it influences your upfront costs of exercising stock options: if it increases, your upfront costs increase with it.

It’s a good idea to ask your company when they expect a re-evaluation so that you can plan for your exercise. Note, however, that they can never be 100% sure: a material event may happen unexpectedly.

Why is the 409A value relevant to startup employees?

The 409A valuation impacts employees in two ways:

• It determines your strike price. Companies almost always set the strike price for new option grants equal to the current 409A. They cannot issue options with a lower strike price.
• It impacts your tax bill. When exercising your options, you are taxed on the difference between their strike price and the current 409A.

For example, let’s say you’re granted options with a strike price of $1 when the 409A is also $1. If you immediately exercise (assuming your company allows early exercising), you wouldn’t need to pay taxes, as the difference between your strike price and 409A valuation is $0.

On the other hand, if you exercise after the 409A is set to $3 at some point in the future, then for every share you exercise, you'll pay tax on the $2 difference.

Why is it called a 409A valuation?

The 409A name comes from IRS Section 409A. This section in the United States tax code addresses how Americans are taxed on deferred compensation such as stock options and equity grants.

Quick FAQs

1. What is the purpose of a 409A valuation?

The 409A valuation determines the fair market value of a private company’s shares, helping set the strike price for stock options and calculating taxes on exercised options.

2. How often is a 409A valuation updated?

• By law, private companies must update their 409A at least once a year or whenever a material event occurs that impacts the company’s valuation.

3. How does the 409A valuation affect taxes on stock options?

The difference between the 409A valuation and your stock option’s strike price is subject to tax. If the 409A is higher than your strike price, you’ll owe taxes on the difference when you exercise your options.

4. Can I ask my employer for the latest 409A valuation?

Yes, most companies provide the current 409A upon request, and it’s a good idea to ask if you’re planning an option exercise. The 409A valuation determines the fair market value of a private company’s shares, helping set the strike price for stock options and calculating taxes on exercised options.