When to Get a 409A Valuation and Keep Your Safe Harbor

Section 409A of the Internal Revenue Code governs deferred compensation. If an option is granted with an exercise price below fair market value, it can be treated as deferred compensation that doesn't meet the rules. The employee can then owe income tax on the option as it vests, an additional federal tax on top and interest, and some states add their own penalties.

That puts the cost on your employees rather than the company, which is why careful founders take it seriously. The fix is to set the strike price on a documented appraisal of common stock. Common stock is worth less than the preferred shares your investors buy, since preferred carries liquidation preferences and other rights, so the 409A number is typically well below the last round's price per share.

Tax rules vary by situation and change over time, so confirm the details with your tax advisor or attorney.

Get one before any of these events:

• Your first option grant, including grants to a founder or early advisor.
• Any new option grant more than twelve months after the last valuation.
• Your first grant after a priced financing closes.
• Your first grant after a material event, such as a term sheet, an acquisition offer, a major customer win or loss, or a sharp change in revenue.

You don't need one just to form the company or issue founder shares at formation. If you're issuing restricted stock to a founder, talk to your attorney about timing and tax elections, because those rules are different from option rules.

The regulations give a presumption of reasonableness to a valuation done by a qualified independent appraiser, as of a date within the prior twelve months, that doesn't ignore information that arose after it. If your grant relies on that valuation, the IRS can only challenge the price by showing it was grossly unreasonable.

The safe harbor breaks in two ways. The valuation gets old: past twelve months, you've lost the presumption. Or a material event happens: if it would change the value, a valuation from before the event no longer counts. A common mistake is signing a term sheet on Monday and granting options on Tuesday using a valuation from last spring.

Practical rule: pause option grants from the moment you sign a term sheet until you have a new valuation on the closing date's information, then grant in a batch. Your board should approve each grant and note the valuation it relied on.

Appraisers generally combine methods. A market approach looks at what comparable companies or recent transactions imply. An income approach projects cash flows and discounts them. For venture-backed startups, appraisers often use an option-pricing model to split total equity value among common, preferred and options, sometimes anchoring on the last round price (a backsolve).

The appraiser will also apply a discount to reflect that common shares are illiquid and lack the preferred's rights. You'll be asked for your cap table, financial statements, forecast, pitch materials and a list of recent events. Better inputs make a stronger report. If you're worried about how the valuation would stand up to scrutiny, read the guide on 409A valuation audit defense.

Cap table platforms and independent firms both offer 409A reports. When comparing, ask what the turnaround is, whether the provider will defend the report if the IRS or an acquirer asks, what data they need from you and how they handle refreshes after a priced round. Confirm the appraiser is independent and qualified, and get the answers in writing rather than relying on the sales page.

Compare options in Carta vs Shareworks vs Pulley for 409A and the early-stage 409A comparison of Pulley and Carta.

Common mistakes to avoid:

• Granting options between a financing and the refreshed valuation.
• Giving the appraiser an outdated cap table or forecast.
• Using the last round's preferred price as the strike, which overprices the option and hurts your hiring offers.
• Forgetting to record the board approval that cites the valuation.