409A Valuation Guide: Importance of 409A Valuations

In recent years, big-box cap table software providers have flooded the market with ultra-low-cost, automated 409A valuations. These venture-backed companies use low pricing as a marketing tool to capture clients. However, their offerings often fail to deliver a defensible valuation, exposing you to risks such as option repricing and potential tax penalties if the valuation doesn’t pass an audit. Here are some of the biggest risk factors when using big-box automated providers: 

Incompetent Valuations: Automated 409A providers often missprice options due to minimal time spent on understanding the client’s business, leading to errors such as inaccurate stock price estimates and calculation mistakes.

Venture-Backed Risks: Venture-backed firms prioritize investor returns, risking business failure or discontinuing services—leaving clients vulnerable in the event of an audit. Redwood, by contrast, is owned and operated by dedicated appraisers who provide reliable, long-term support.

Lack of Customer Service: Big-box providers offer poor customer service, prioritizing secondary market sales over personalized, high-quality valuations. They fail to invest time in understanding clients' goals.

Inexperienced Appraisers: Unlike big-box providers who outsource low-cost labor overseas, Redwood employs appraisal experts with over 100 years of combined experience, offering personalized, defensible valuations backed by industry-leading expertise.

If you’re issuing options in a private company, a 409A valuation is essential. The key takeaway is to avoid cap table management companies offering valuations where appraisal and accounting aren’t their core competency, because they often oversimplify the process, leading to potential problems. Instead, choose a qualified provider like Redwood Valuation for accurate, defensible results tailored to your business.

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Internal Revenue Code Section (“IRC”) 409A is a complex regulatory framework that was introduced in 2005. It specifies that private companies are required to issue stock option awards with strike prices either at or over the fair market value. Section 409A places different types of qualified deferred compensation into five categories: qualified employer plans, foreign plans, section 457 plans, welfare benefits, and stock options. It also outlines timing restrictions, such as when qualified and unqualified plans can be payable, and the penalties for violating these rules.

IRC 409A also outlines which aspects of a business are relevant to its valuation. This includes things like the value of assets, cash flow, control premiums, and marketability. Understanding these regulations and considering all elements that the IRS weighs is key to avoiding financial consequences, which is why help from a valuation professional is so essential. Complying with IRC 409A also ensures that new startups get off on the right foot, both in terms of complying with federal and state law (where applicable) and laying the groundwork to incentivize or reward employees and attract new hires using deferred compensation.

The IRS implemented IRC 409A shortly after the Enron scandal, where the company’s executives were accelerating payments under deferred compensation plans. This allowed them to access that money before the company declared bankruptcy. Employees and shareholders may now be penalized and fined if a company does not adhere to the regulations outlined in IRC 409A. However, safe harbor status helps avoid these penalties.

Safe harbor effectively means that your company will be protected from IRS audits, as the IRS must accept the valuation unless they can prove that it meets a standard of being “grossly unreasonable.” If a company does not have safe harbor status and fails an IRS audit, they may be exposed to additional taxation, tax penalties, and a full refunding of employee contributions to qualified retirement plans. Further, based on some of the “grossly unreasonable” work we have seen from big box “automated” providers, it would not be surprising to see more employees/companies left exposed to IRS penalties after receiving poor quality valuations from such providers (i.e. providers that focus on cap tables or secondary markets.

What Is IRC 409 or Section 409A?

Companies often want to grant options to employees as part of an equity-based compensation package. Federal laws require a valuation before doing this to ensure that the exercise price reflects the fair market value. Per Internal Revenue Code Section 409A, a grant with an exercise price below the fair market value triggers a tax penalty.

IRC 409A valuations are uniquely relevant to private companies since public companies have traded market prices that determine the fair market value of the stock used to set the option exercise price. 409A valuations determine the fair market value of common stock in order to price options on common stock and should come from qualified and independent appraisers.

Fair market value is defined by the IRS as the price at which a willing buyer and a willing seller, both under no compulsion to buy or sell, each with sufficient knowledge enter into a transaction to buy or sell an asset. As a company reaches its milestones, the periodic nature of these valuations ensure that the business’s fair market value is accurate and up to date.

The IRS regulates 409A valuation standards, and audits are possible. Scrutiny from financial statement auditors or the SEC in accordance with ASC 718 are more likely and also carry significant risks.  As such, reputable valuation providers often include or offer audit defense as a service for this reason. Failure to complete regular 409A valuations and adhere to IRS guidelines can lead to tax penalties and other financial consequences including but not limited to a 20% penalty tax and additional interest rate charges based on the date of value.

Note that 409A valuations are only valid for limited periods of time. They expire after twelve months or after a material event occurs that could impact the business’s fair market value. For example, a startup completing a funding round is considered a material event and requires a new 409A valuation to receive safe harbor under IRC 409A .

Generally speaking, a material event is any occurrence that will change the company’s financial condition, business strategy, or mission. Other than closing a funding round, material events include such things as:

  • A major merger or acquisition.

  • A significant pivot in business or operational strategy.

  • Substantially surpassing the forecasted progress associated with an earlier valuation.

  • Forging or ending a major strategic partnership with another company.

  • Changing the company’s legal status (ex. LLC to Inc.)

  • Engaging in the sale of company assets, business units, etc.

If any of these events occurs, you need a new 409A valuation regardless of whether you are within twelve months of the previous one.

Valuation for a private business is determined by an expert who estimates your company’s fair market value. In the event of an audit, the IRS will conduct its own review of your organization’s accounts and information to ensure that its value was accurately reported.

In order to estimate the fair market value of your company, an appraiser will typically rely on one or more of the following approaches:

What Is 409A Valuation?

This approach uses various financial statement metrics of similar enterprises’ equity securities, assets, or investments to estimate the fair value of the Company’s equity securities, assets, or investments. The best determinate for ascertaining fair market value of equity securities of a company is the quoted market price of an active market for the equity securities.

By definition, illiquid stock (stock that is not traded on an active market) has no quoted market price. In some instances, a company may enter into arms-length transactions for the sale of its equity securities. These transactions may qualify as a quoted market price and be considered the best measure of fair value provided that the equities sold in the transaction are the same securities for which fair market value is being determined, and the transaction is a current transaction between willing parties (not forced or in a liquidation sale).

Market Approach

This approach derives value by estimating reasonable future cash flows to the firm and/or equity holders and discounting them to present value using a risk-adjusted discount rate or capitalization rate consistent with the riskiness of the forecasts. Limitations under this approach rest on the validity of the forecasts and the underlying assumptions. The income approach is more effective for later-stage companies due to there being an established operating and financial history on which forecasts are predicated. We did not weight the concluded value derived from this approach as discussed below.

Income Approach

This approach focuses on the fair market value of the Company’s net assets. The approach is most appropriate for earlier stage companies that are in early-stages of development, have small or modest intangibles and goodwill, a relatively small amount of cash has been invested, and where the market or income approaches have no or limited basis.

In selecting a methodology to apply, a qualified valuation firm should consider relevant factors of the business to deliver a meaningful and defensible value estimate. There are no “cookie-cutter” valuations as each analysis must be uniquely tailored to a company’s individual circumstances (hence why using big box “automated” providers can be very problematic).

Working with a firm that has sufficient experience and qualifications can ensure that you not only have an updated report in compliance with IRS requirements but also that the methods relied upon are most appropriate for the risk profile of the company being valued.

Asset Approach

Even if your business is only a small startup, if you offer stock options, you should consider a 409A valuation to receive safe harbor. However, 409A valuations for startups don’t always look the same as those for other types of businesses. In fact, startups present some unique challenges when it comes to valuations.

For example, many startups have limited to no income. This means that it may be difficult to apply a traditional income approach to gauge the enterprise value. Additionally, a startup may not compete in a universally defined industry, and as such, it may make traditional market comparisons within the market approach problematic. In these situations, valuation firms will often employ methods for startups that specifically address these challenges. A couple of examples include:

How Startup Valuation Works

The Backsolve method (or OPM Backsolve method) calculates an implied fair market value for the company and its stock based upon the company’s most recent round of funding, capital structure, and any other potential financial instruments that the company may hold.

Backsolve

This method estimates the cost of building a comparable company from the ground up, including opportunity costs and reasonable profit margins, as appropriate. Popular among investors, this approach assumes that a savvy investor wouldn’t pay more than the standard cost to recreate the assets from scratch to invest in a startup.

While it may be possible for some startup or small-business owners to complete 409A valuations on their own, the risk is generally too high and the methods too complex. Additionally, startups often experience rapid growth or progress through several material events in a relatively short span of time, which further intensifies the need and regularity of audit ready valuations.

Given the unique challenges and business circumstances that startups face, coupled with the serious consequences that come with not complying with IRS regulation and guidelines, it is often better to work with a firm experienced in the special valuation techniques that are ideal for earlier stage and rapid growth companies.

The cost of a valuation varies based on circumstances such as the size of the company, complexity of its capital structure, and scope of work. Similarly, the length of time needed to complete a valuation also varies; generally, between two and four weeks. Regardless of time and cost, the most important consideration is that you choose to work with a firm that will help ensure the best possible outcome for your business.

Cost-To-Recreate

Valuation of your enterprise can be complex, regardless of it you are launching a new startup, growing a closely-held business, or playing a key role in a large, international corporation. There are a lot of valuation charlatans out there, particularly the big box “automated” providers, so it is critical to get valuations from reputable experts with significant valuation experience. If it has been a year since your last valuation or your enterprise has undergone a material event, connect with Redwood Valuation so that we can help guide you through the 409A valuation process.

409A Valuation Conclusion

Section 409A of the IRS tax code refers specifically to “nonqualified deferred compensation.” This refers to several types of compensation you might be offering your employees and contractors. The IRS defines it this way:

Section 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.

What does this mean for your startup or small business? Basically, if you pay your employees or contractors partly with stocks or stock options then you need to file under section 409A.

What Does 409A Mean

If the above description applies to your startup or small business then you may need a 409A valuation. But just what is a 409A valuation?

In a 409A valuation, an expert appraises the fair market value of the company or business’s common stock.

The complexity of this valuation varies broadly depending on whether the stock in question is publicly traded or private company stock. With publicly traded stock, it’s possible to simply look at the prices of the stock on public exchanges and markets. However, when it comes to private company stock, an independent valuation is required in order to assess the value of the stock.

Put simply, a 409A valuation is just a way to determine the value of the stock you compensate your employees and contractors with. This includes:

  • Stock options

  • Stock awards

  • Stock appreciation rights

What is a 409A Valuation

409A valuations are crucial to get if you need one. They will help you avoid tax issues when it comes to the IRS. Not only you but also your employees could be on the hook with the IRS for a lot of money if you don’t get a 409A valuation when you need one.

If, for example, you gave your employees and contractors an option to buy 500 shares at $1 per share, you need a 409A valuation. Without that valuation, the IRS could later tell you that the stocks were worth $2 a share on that date. Your employee would have to pay the difference PLUS a penalty of 20% of the price difference. In the example here, that would mean more than $1000 in sudden fines. And don’t forget that the IRS will charge interest on any fines or fees.

The cost of NOT getting a 409A valuation can be very steep for you and your employees.

Why Is a 409A Valuation Important

A 409A valuation report is what an expert will produce when you get a 409A valuation from them. The report should tell you the fair market value of the common stock so you can issue options with a strike price equal or greater than the common stock value and other stock (like RSAs) can be recorded at the fair market value of common stock.

This report will help keep you in compliance with IRS guidelines and rules in regard to the deferred compensation you give your workers. This includes stocks and stock options.

What is a 409A Valuation Report

A 409A valuation doesn’t look at the entire business, only the parts that are relevant to section 409A of the IRS tax code. These parts include:

  • Present value of future cash flows

  • Fair market value of your business compared to similar public and private businesses

  • Control premiums

  • Lack of marketability

  • How this method of valuation is applied in other scenarios

There may be other aspects that apply. It will change depending on the specific business getting the valuation and what it needs. The goal in deciding which factors to consider is to make sure all the deferred compensation you have to report is thoroughly accounted for in the valuation.

Which Aspects of a Business are Considered for a 409A Valuation?

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A big consideration in a valuation is figuring out the “fair market value” of various types of deferred compensation.

Fair market value basically means the price a reasonable person would pay for something. This is a very simple way of defining it, but it is essentially true. Fair market value assumes that the buyers and sellers of an asset are both knowledgeable enough to behave in their own best interest. According to the IRS, fair market value “is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts”.

When it comes to taxes, fair market value is used for more than just 409A valuations. Stocks, property, and insurance claims all also rely on fair market value to come up with fair parameters. In regard to your 409A valuation, fair market value will determine the worth of deferred compensation such as stocks and stock options that you compensate workers with. Fair market value is a crucial concept that will ultimately determine your tax liability in regard to these assets.

What is Fair Market Value?

With stock options being one of the major areas that a 409A valuation looks at, it is important to understand how your valuation may impact stock options.

Sometimes, a 409A valuation will not affect stock options at all. If stock options or stock appreciation rights are at or above fair market value, then you don’t need to worry about 409A when doing your taxes. Of course, you may not know just at a glance if your stock options are at fair market value. It is often better to err on the side of caution and get a valuation to ensure you do not violate any provisions of section 409A.

How Does a 409A Valuation Affect Stock Options?

The answer to how much a 409A valuation costs depends on the complexity of the fact pattern.

It is possible to prepare your own 409A valuation, but we do not recommend going this route as you will not likely have safe harbor under the IRS guidelines. The penalty for doing your 409A valuation wrong or having an error on it is quite high, so you should be very confident about all the assumptions in question if you plan to save money by doing your valuation yourself.

You can also use software and programs to help you do your 409A valuation on your own. This may be okay for some very early startups, but it can still be risky as the software provider may not defend the work and/or the report may not qualify for safe harbor. If the wrong software module is used or the assumptions aren’t properly vetted and defended, you may incur IRS penalties.

Another option is to get an industry leading valuation firm like Redwood Valuation to handle your valuation. Redwood’s experts have decades of experience with hundreds of clients. If you choose us to do your 409A valuation with Redwood, you can be sure you will get a result that the IRS will accept. Being cheap in the short term may result in substantial IRS fees and interest payments later. Get your 409A valuation done right through Redwood.

Home Much Does a 409A Valuation Cost?

There is some variation in the amount of time a full 409A valuation can take depending on the complexity of your business’s finances and payments. We can offer an estimate of a typical valuation, however:

  • 1-3 days: Hand over your data to a professional valuator, including financial projections, past 409A reports (if you have any), articles of incorporation, term sheets, etc.

  • ~3 weeks: Create the analysis and prepare the 409A valuation report

  • 1 day: Review the first draft of the report with the appraiser (this is typically a short appointment of 30 minutes – 1 hour)

  • 1-3 days: Make any needed revisions to the report

  • TBD: Apply the revisions to get your final report

As you can see, there are a lot of variable factors involved in getting a time estimate for a 409A valuation. These time estimates are approximate. We can work with you to give you a more precise time estimate as we proceed through the valuation process, but our valuations generally take 3-4 weeks for a draft report (4-6 weeks for more complex engagements).

How Long Does It Take?

While it’s possible to do your own 409A valuation, we recommend going with a business valuation company like Redwood Valuation Partners to do your 409A valuation.

There are several benefits to having an expert handle your valuation for you. For one, you won’t have to deal with the stress and pressure of getting your valuation perfect in order to avoid fees and penalties from the IRS.

For another, our valuation professionals are experts in their field who have decades of experience. You can trust they will do your valuation right the first time, saving you time and money over less experienced valuators. Plus, they can handle your business no matter what its particulars involve. Redwood has a diverse range of clients, from rapidly growing startups to very large private equity backed multinational companies.

Why Should You Hire a Business Valuation Company to Do Your 409A Valuation?

Business appraisers can provide you with a 409A valuation. Redwood Valuation Partners is one such valuation company. We would be happy to work with your on your 409A valuation. Here are just a few of the benefits of working with us for your 409A valuation:

  • We have had more than 1,000 clients trust our work

  • We have expert knowledge in the fields of finance, tax, venture capital and the audit process

  • We understand the pressures of running a startup or small business

  • Our team includes experienced associates and analysts with decades of knowledge

  • We will defend your valuation at any point

  • We will perform your valuation without unreasonable fees

  • We have existed for as long as the IRC 409A (of the IRS code) has existed

Where Do I Get a Formal 409A Valuation?

Redwood specializes in working with early-stage and high-growth companies like startups. We can help startups looking for help with their 409A valuations.

The first step for a 409A valuation will be turning over all relevant company information. Once we have this information, we can run the report needed for the valuation.

With this report in hand, the next step is to review it with you and make sure we haven’t missed anything. We’ll make revisions together and then our experienced valuators will produce a final report.

Guide to 409A Valuations for Startups

You need a 409A valuation as soon as you issue your first employee stock options. After that point, you will need to get a 409A valuation every 12 months. They are only good for the current tax year, so make sure you stay on top of redoing the valuation every year (or more frequently if needed).

Also take note of any time your company experiences big changes. You may need to get another 409A valuation depending on what type of major change occurs.

When Do You Need a 409A Valuation?

Your first 409A valuation may coincide with the start of your company. However, you may not need a 409A valuation until later. As soon as you start issuing employee stock options or other deferred compensation, you will need a 409A valuation.

When Should You Get Your First 409A Valuation?

Don’t jump the gun on 409A valuations when you may not actually need one. Here are some scenarios where you don’t actually need a 409A valuation:

  • If you run a public company you can issue stock options in such a way that you don’t actually need to get a 409A valuation

  • If you don’t issue any stock-based compensation to your employees you do not need to get a 409A valuation

Reasons to Not Use a 409A Valuation

Of course, the flip side is the many companies who do actually require a 409A valuation. Here are some scenarios where you do need a 409A valuation:

  • When you want to ensure you’re following all applicable tax laws to avoid problems during an IRS audit

  • When you issue stock-based compensation to your employees

  • When you want to ensure your employees will not run into tax trouble

Reasons to Use a 409A Valuation

The deadline for a 409A valuation depends on when and why it was initiated. The deadline for a valuation may be immediate if you have just issued stock options to your employees.

You also need to make sure you have a new valuation done if it has been 12 months since the first valuation was performed.

A third deadline approaches if you have recently made big changes at your company. Once you do this, you may need to get a valuation quickly (as in the first scenario) to ensure you are still in compliance with section 409A of the tax code.

Deadlines for a 409A Valuation

Common Mistakes With 409A Valuations

Frequently Asked Questions

  • If your company is private and plans to issue compensation in the form of equity (most commonly, stock options), then a 409A valuation is the best and easiest way to receive safe harbor from IRS scrutiny under IRC 409A. Additionally, there are numerous other, and perhaps more important, reasons to get a 409A valuation for your company.

  • A 409A valuation is good for 12 months or until a material event occurs. When evaluating whether a material event has occurred, you should consider outside investments, recent rounds of financing, M&A activity, major changes in the management team, financial performance different than forecasts, changes to the business model, and similar events. We are happy to help you navigate this issue with a free consultation.

  • While we specialize in early-stage and high-growth companies, our clients have ranged from pre-revenue startups to mature companies with over $1 billion in revenue. Although we perform hundreds of valuations for life science, medical device, and early-stage tech companies, we have experience valuing a wide array of industries from architecture to food manufacturing and distribution to vehicle leasing and much more.

  • A basic 409A or business valuation generally takes 3 to 4 weeks to complete a draft report. More complex engagements, such as purchase price allocations, may take 4 to 6 weeks. We try to work with our clients to meet your needs and may be able to expedite our deliverables upon request.

  • To start, we have a kick-off call to better understand your needs and your business. We provide a straightforward request list and incorporate as much of it into our model as possible. We may have follow-up questions or calls, but we keep the process as efficient as possible. The final deliverable is a robust, written report. You may ask us questions throughout the process and we value your feedback.

  • The founders of Redwood have been around since IRC 409A came into existence and have built a loyal team that will be familiar with your business from year-to-year and defend your valuation at any point. Unlike venture-backed, online-based valuation providers that may run out of cash and large consulting firms that inevitably have high turnover, we are guaranteed to be around in 5 years and will have our core team in tact. Additionally, we will defend your valuation without unreasonable fees.

  • No rules of thumb exist regarding common as a percent of preferred. The value of common is impacted by the rights and privileges of the various share classes. However, in our experience management often has a good sense of what the final value should be. Our valuation conclusions are considered to be very reasonable by both management and regulators.

IRS Tax Code Defines “Key Employee”
(1) Key employee
(A) In general
The term “key employee” means an employee who, at any time during the plan year, is—
(i) an officer of the employer having an annual compensation greater than $130,000,
(ii) a 5-percent owner of the employer, or
(iii) a 1-percent owner of the employer having an annual compensation from the employer of more than $150,000.
For purposes of clause (i), no more than 50 employees (or, if lesser, the greater of 3 or 10 percent of the employees) shall be treated as officers. In the case of plan years beginning after December 31, 2002, the $130,000 amount in clause (i) shall be adjusted at the same time and in the same manner as under section 415(d), except that the base period shall be the calendar quarter beginning July 1, 2001, and any increase under this sentence which is not a multiple of $5,000 shall be rounded to the next lower multiple of $5,000. Such term shall not include any officer or employee of an entity referred to in section 414(d) (relating to governmental plans). For purposes of determining the number of officers taken into account under clause (i), employees described in section 414(q)(5) shall be excluded.
(B) Percentage owners
(i) 5-percent ownerFor purposes of this paragraph, the term “5-percent owner” means—
(I) if the employer is a corporation, any person who owns (or is considered as owning within the meaning of section 318) more than 5 percent of the outstanding stock of the corporation or stock possessing more than 5 percent of the total combined voting power of all stock of the corporation, or
(II) if the employer is not a corporation, any person who owns more than 5 percent of the capital or profits interest in the employer.
(ii) 1-percent owner
For purposes of this paragraph, the term “1-percent owner” means any person who would be described in clause (i) if “1 percent” were substituted for “5 percent” each place it appears in clause (i).

(iii) Constructive ownership rulesFor purposes of this subparagraph—
(I) subparagraph (C) of section 318(a)(2) shall be applied by substituting “5 percent” for “50 percent”, and
(II) in the case of any employer which is not a corporation, ownership in such employer shall be determined in accordance with regulations prescribed by the Secretary which shall be based on principles similar to the principles of section 318 (as modified by subclause (I)).
(C) Aggregation rules do not apply for purposes of determining ownership in the employer
The rules of subsections (b), (c), and (m) of section 414 shall not apply for purposes of determining ownership in the employer.

(D) Compensation
For purposes of this paragraph, the term “compensation” has the meaning given such term by section 414(q)(4).

Definition: What is a Key Employee?

If you are not compliant with section 409A then you can be audited by the IRS. Audits are not only expensive, they are also time-consuming. Plus, you are likely to face taxes and penalties.

What are the Consequences of 409A Non-Compliance?

Section 409A came about on January 1, 2005, as part of the American Jobs Creation Act of 2004. It was added to the IRS tax code in order to broadly address all forms of deferred compensation and ensure businesses are in compliance.

Part of the impetus for creating section 409A was questionable business practices at Enron. Enron executives used deferred payments to access money shortly before the company went bankrupt. This allowed them to escape certain loses they may have suffered otherwise.

Another reason for the creation of 409A was the IRS’ concern over historical tax-timing abuse.

The IRS was initially slow to enforce 409A, then started to examine select large employers for compliance. This indicates that the IRS is moving to refine the standards of 409A and will start evaluating more and more businesses for compliance. In 2014, the IRS conducted a limited audit initiative to see how well businesses were complying with section 409A. This may produce a nasty surprise for businesses who aren’t prepared for a section 409A audit.

Self-auditing is recommended for all businesses trying to stay in compliance with section 409A. You may be able to find problems before you have to deal with a much scarier, costlier, and more time-consuming IRS audit.

History of 409A Valuations and Cases of IRS Enforcement