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A 409A valuation is an assessment of the fair market value of a private company’s common stock by a third-party, independent appraiser. The result of the assessment is communicated in a written valuation report to the company’s board of directors, which uses the report to determine and set the price at which people may purchase shares of the company’s common stock.

The name of this valuation comes from Section 409A of the U.S. Internal Revenue Code (the “tax code”). Among other things, Section 409A requires that options granted as compensation to service providers have an exercise price (also known as strike price) equal to or greater than the fair market value of the shares underlying the options on the date the options are granted. If it is discovered in an audit that options were granted with an exercise price below fair market value, then the service provider who received the underpriced options may be subject to severe tax penalties.

Obtaining a 409A valuation from an independent appraiser is one of the “safe harbor” methods of determining fair market value detailed in the tax code. If a company does not use a safe harbor method to determine the value of its stock, then the valuation it arrives at has no presumption of validity, and in the event of an audit, the company has the burden of proving its valuation is reasonable, which may involve producing extensive financial documentation from around the time of its option grants. If instead, a company uses a valuation safe harbor, then the valuation that it obtains is presumptively valid, and the burden of proof shifts to the Internal Revenue Service (IRS) to show that the valuation is “grossly unreasonable,” which is widely considered to be a high threshold. 409A valuation reports are valid for one year following the date of the valuation, unless a material event occurs that affects the valuation of the company’s stock (e.g., a venture financing).

Prices for independent 409A valuations typically cost several thousand dollars per year, though prices may vary across firms and based upon the amount of work required to draft the valuation report. This may seem like a high cost to bear for a startup company with limited resources, but the consequences of making mispriced equity awards can effectively wipe out much of the value of such awards. Also, a company that does not use a 409A safe harbor to determine fair market value when making equity awards may experience increased deal friction when raising financing or at the time of an exit (i.e., an acquisition or an IPO) because compliance with Section 409A is a point of legal and tax scrutiny.

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