A startup should have its first 409A valuation right before issuing stock options. This is when an independent firm appraises your common stock’s fair market value and that number becomes the exercise price for every option grant issued under it. You might need a new valuation after a priced funding round, a material change in the business (e.g., a major new contract, an acquisition offer), or after the initial one expires. If you miss one of those markers, your company and option holders will lose their protection from IRS penalties.

Below, we’ll explain what a 409A valuation for a startup measures, why it matters for tax compliance, and what happens if you let a valuation lapse.

Key takeaways

• A 409A valuation sets the fair market value used to price stock option exercise prices and keeps grants compliant with IRS rules.

• Startups typically need a new valuation after funding rounds, on the 12-month safe harbor anniversary, or after a material business change.

• Skipping a valuation or letting it lapse exposes employees to tax penalties and can stall financing rounds or acquisitions during due diligence.

What is a 409A valuation for a startup?

A 409A valuation is an appraisal—often conducted by a qualified outside firm—that establishes your company’s fair market value, or what its common stock is worth. This matters because the IRS requires any stock option you grant to carry an exercise price at or above fair market value on the date you grant it.

The valuation involves common shares, which represent an ownership stake in a corporation and provide voting rights on corporate decisions. Common shares differ from preferred stock, which doesn’t usually carry voting rights but typically pays its owners dividends before common stock shareholders and might give them an earlier claim to assets if the company liquidates.

Why does a 409A valuation matter for compliance?

If you grant options below fair market value without a valid 409A valuation behind the number, the IRS can reclassify them as nonqualified deferred compensation. That reclassification applies to the company and those who’ve vested. The option holder owes an additional 20% penalty tax, due immediately on vesting (not when they exercise or sell), plus interest. Some states add more. For example, California layers a 5% penalty on top of the federal one.

A current 409A valuation helps protect your team from those penalties and can give you a safe harbor presumption of reasonableness if the IRS challenges your numbers. Under that presumption, the burden shifts to the IRS to prove your valuation was unreasonable, which is an easier position to defend than starting with no valuation.

When should a startup get a 409A valuation?

A startup needs a fresh 409A valuation more often than some might expect. The standard safe harbor period runs 12 months from the valuation date.

Here are timing considerations:

• Before your first option grant: You’ll want to receive a 409A valuation before you issue stock options. Typically, businesses obtain one shortly after incorporation, once it’s ready to hire employees or advisers.

• After every priced funding round: A new round of equity financing sets a new price for preferred stock, and that almost always changes the fair market value of your common stock.

• On the 12-month anniversary of your last valuation: Even if nothing else has changed, the safe harbor will expire, and you’ll need a new one.

• After a material change in the business: A signed acquisition offer, a major new customer contract, an important product launch, or a substantial shift in revenue can necessitate a new valuation early, regardless of how much time remains on your safe harbor.

• Before a tender offer or secondary sale: Existing shareholders who sell stock to new investors need current pricing to support the transaction.

How does the 409A valuation process work?

The 409A valuation process has several steps:

Engage a valuation firm

Many startups hire an independent third-party firm rather than perform the appraisal in-house because that’s one way to satisfy the IRS’s safe harbor requirements.

Provide your data

You’ll provide financial statements, your cap table, your business plan, recent board minutes, and details on any recent financing.

The firm applies a valuation methodology

Early-stage companies without much financial history often use the option pricing model (OPM), which treats different equity classes as options on the company’s total value. Later-stage companies with more predictable outcomes might use a probability-weighted expected return method. Companies close to a financing event often “backsolve” (i.e., work backward from a target value using OPM to find the total value) the common stock value from the price investors just paid for preferred shares.

The firm applies a discount for lack of marketability

Because your common stock won’t be able to trade on a public exchange, the appraised value will be reduced to reflect that illiquidity. This typically brings the common stock price down to a fraction of what preferred investors paid.

You receive a formal report

After getting the report, your board will formally adopt the valuation.

Turnaround and cost vary with company complexity and the firm you work with. If you incorporate through a service such as Stripe Atlas, you’ll set up your Delaware C corporation and establish a basic equity structure. That formation work doesn’t include the 409A valuation, which is a separate, ongoing compliance step.

How does a 409A valuation affect equity compensation?

The 409A valuation helps determine the strike price on every option grant that follows it. When your board approves new grants, whether for a new engineer or an adviser, the exercise price is set at or above the fair market value your most recent valuation established. That price stays fixed for that grant no matter what happens with the company’s value afterward so an employee’s potential gain is the spread between what they paid to exercise the option and what the stock is worth later. A properly priced grant legitimizes that spread so it’s more than a disguised discount.

Your choice of option type also interacts with the valuation. Incentive stock options (ISOs) and nonqualified stock options (NSOs) need to be priced at fair market value to avoid tax penalties, but they’re taxed differently at exercise. NSO holders owe ordinary income tax on the spread right away, while ISO holders can potentially defer taxation and qualify for capital gains treatment if they meet specific holding period requirements. Staying current on your valuation is an ongoing part of running a compliant equity compensation program alongside board approvals, option agreements, and cap table maintenance.

What happens if a startup skips a 409A valuation?

Your employees would pay the most immediate cost of skipping a 409A valuation. Option holders can face ordinary income tax, the 20% federal penalty, accrued interest, and possibly a state penalty. For the company, a missing or lapsed valuation will be noticed during diligence for your next financing round or any acquisition conversation. That kind of gap can stall a deal while everyone tries to figure out the exposure. In some cases, a buyer or new investor will require you to fix the problem, sometimes by repricing or reissuing affected grants, before they’ll close.

How Stripe Atlas can help

Stripe Atlas handles everything you need to legally launch your company—incorporation, Employer Identification Number (EIN), equity setup, and tax filings—so you can fundraise, open a bank account, and start accepting payments in as little as two business days, from anywhere in the world.

Join 100,000+ startups incorporated using Atlas, including startups backed by top investors like Y Combinator, a16z, and General Catalyst.

Get started in minutes with Atlas

The application takes under 10 minutes. You’ll choose your company structure, confirm your name is available, add up to four cofounders, set your equity split, and e-sign. Then, Atlas takes it from there, including notifying cofounders to sign their documents electronically.

Banking and payments before your EIN arrives

Atlas files your EIN application automatically after incorporation. You don’t have to wait. Atlas enables pre-EIN payments and banking so you can start accepting payments and making transactions right away. US founders with a Social Security number are typically eligible for expedited IRS processing.

Automatic 83(b) tax election filing

Atlas files your 83(b) election for you—US and non-US founders alike—with US Postal Service certified mail and tracking to reduce personal income taxes. You’ll get a signed 83(b) election and proof of filing directly in the Stripe Dashboard, with certified mail confirmation.

World-class company legal documents

Atlas provides all the legal documents you need to start running your company—drafted by Cooley, one of the world’s leading venture capital law firms—and stores them directly in the Stripe Dashboard. These documents are designed to help you fundraise immediately and ensure your company is legally protected, covering aspects like ownership structure, equity distribution, and tax compliance.

$2,500 in Stripe credits, plus $50K+ in partner discounts

Atlas startups get $2,500 in Stripe product credits for their first year, plus $50,000+ in discounts on essential tools—Mercury, AWS, Carta, Xero, Perplexity, and more. Delaware registered agent service is also included free for your first year.

Learn more about how Atlas can help you set up your new business quickly and easily, or get started today.

FAQs about 409A valuations for startups