409A Valuation Guide | How It Affects Your Stock Options

Equity compensation is one of the most powerful wealth-building tools for employees at high-growth startups and private companies. However, to truly understand the value of your stock options, you need to be aware of one key aspect: the 409A valuation.

If you’ve ever looked at your stock option grant and wondered how the strike price was set, the answer lies in this valuation. It’s not just a technical requirement; it directly impacts the financial upside of your equity and the taxes you may owe.

This article breaks down how 409A valuations are determined, why they matter, how they compare to other valuations you’ll hear about, and what every employee should know.

A 409A valuation is an independent appraisal of the fair market value (FMV) of a private company’s common stock.

It’s named after Section 409A of the Internal Revenue Code, which sets rules for nonqualified deferred compensation. Stock options fall into this category, and the IRS requires companies to set the strike price of options at or above the FMV of common stock on the grant date.

Why it matters:

• Sets the strike price for incentive stock options (ISOs) and non-qualified stock options (NSOs).
• Provides IRS compliance, avoiding harsh penalties if options are granted below FMV.
• Protects both the company and employees with a “safe harbor” valuation if done by a qualified third party.

By law, companies must refresh their 409A valuation at least every 12 months or sooner if a “material event” occurs, such as a new funding round or a significant acquisition offer.

Companies typically hire independent valuation firms that specialize in valuing startups and private companies.

When done by a qualified third party, the valuation receives a safe harbor designation. That means the IRS assumes it’s valid unless they can prove otherwise. Without a safe harbor, the burden of proof falls on the company and employees, a much riskier position.

While very early-stage startups sometimes use automated valuation software, most venture-backed companies quickly move to full independent appraisals, especially once they begin raising institutional capital.

Valuation experts use a blend of methodologies and data points. No single approach works for all companies; the mix depends on the company’s stage, revenue, growth potential, and capital structure.

Income Approach

• Projects future cash flows and discounts them to present value.
• Best suited for companies with more predictable revenues.

Market Approach

• Compares the company to similar publicly traded companies (public comps) or private market transactions.
• Adjustments are made for company size, growth, and risk.

Asset Approach

• Values the company based on the net value of its tangible and intangible assets.
• More common in early-stage or asset-heavy businesses.

This is a critical distinction for employees:

Preferred stock (what venture investors buy) comes with liquidation preferences, dividends, and other protections.

Common stock (what employees receive) lacks these benefits and therefore has a lower value.

👉 Example:

A Series B investor pays $10/share for preferred stock.

After applying discounts for lack of marketability and the absence of preferred rights, the 409A FMV for common stock is set at $3/share.

If you’re granted 10,000 options after this valuation, your strike price is $3/share.

Your company’s 409A valuation isn’t just paperwork; it directly affects the wealth-building potential of your stock options.

Grant details: 10,000 ISOs at a strike price of $3/share (based on 409A).

Company IPO price: $40/share.

At exercise:

Cost to exercise: 10,000 × $3 = $30,000.

Value at IPO: 10,000 × $40 = $400,000.

Gain: $370,000.

If the 409A valuation had instead been $8/share, your cost to exercise would have been $80,000, and your net gain at IPO would drop to $320,000.

That difference, $50,000, is entirely due to the strike price set by the 409A valuation.

If a company grants options below FMV, the IRS can reclassify the options as deferred compensation under Section 409A, triggering:

Immediate taxation on vesting, not just on exercise.

An additional 20% penalty tax, plus interest.

This is why companies invest in professional valuations to protect employees and maintain safe harbor compliance.

"It's the same as the company’s fundraising valuation."
False. Investor valuations reflect preferred stock with protections. Common stock FMV is usually lower.

"A higher 409A means my options are overpriced."
Not necessarily. A higher strike price often signals company progress and higher potential exit value.

"Once set, it never changes."
Companies must update 409As annually or within 30 days after any material events.

At least every 12 months.

After new funding rounds, major M&A, or material financial shifts.

Some fast-growing companies update quarterly to stay compliant.

Employees at pre-IPO companies often hear multiple valuation numbers thrown around, which can be confusing. Here’s how they differ:

Purpose: Compliance with IRS rules; sets strike price for stock options.

Frequency: At least annually or after material events.

Value: Typically, the lowest number of employees see, since it applies discounts for lack of marketability and absence of preferred rights.

Purpose: The Price institutional investors pay in a funding round.

Reflects: Preferred stock rights (liquidation preferences, dividends, anti-dilution).

Difference: Usually much higher than 409A because preferred stock has protections.

Employee impact: Does not set strike price but signals investor appetite and company growth.

👉 Example: Series B round at $10/share preferred, but 409A FMV sets common stock at $3/share.

Purpose: Applies when employees receive restricted stock or when they have the ability to early exercise their stock options and choose to file an 83(b) election.

Value: Based on FMV of common stock at the time of grant or exercise (usually determined by the 409A).

Employee impact: Filing an 83(b) election allows employees to pay tax on the low current valuation upfront, rather than on a potentially much higher value when the stock vests. This can significantly reduce long-term tax exposure if the company experiences growth.

👉 Example:

You’re granted 10,000 stock options with a strike price of $1/share (based on the 409A valuation).

You early exercise immediately and file an 83(b) election.

At grant, FMV = $1, strike = $1 → no taxable spread, so you owe $0 tax.

Now imagine you don’t early exercise:

Over 4 years, the company grows and FMV rises to $10/share.

As each tranche of stock vests, you’re taxed on the spread: $10 − $1 = $9 per share.

For 10,000 shares, that’s $90,000 of ordinary income taxed at your marginal rate - simply because you didn’t file the 83(b) early!

By filing the 83(b) at the start, you lock in today’s low valuation and avoid tax on the growth until you actually sell the shares (at which point gains are treated as capital gains).

Purpose: Reflects what private shares might fetch if sold in a secondary transaction.

Value: Depends on buyer demand, restrictions, and timing.

Difference: Often higher than the 409A but lower than IPO pricing.

Employee impact: Useful for gauging “real-world” liquidity value but does not affect strike price.

• Ask about timing: Know when your company last completed a 409A valuation.
• Understand the strike price: It’s tied directly to 409A FMV.
• Recognize opportunity: A lower strike price at grant is generally favorable.
• Plan ahead: Equity decisions (exercise, hold, or sell) should be modeled with professional tax and financial guidance.

The 409A valuation is the foundation of your stock option pricing, but it’s just one piece of the puzzle. By understanding how it compares to preferred stock pricing, 83(b) elections, and secondary market valuations, you gain a clearer picture of your true equity value.

At VIP Wealth Advisors, we help employees and executives at pre-IPO companies translate these numbers into real wealth strategies. The 409A may set the starting line, but how you plan your equity exercise and exit will determine where you finish.