What Is a 409A Valuation?

A beginner’s guide to understanding private company valuations and what they mean for an investor.

If you’ve invested in a private company or received equity as part of a startup, you may have heard the term "409A valuation" thrown around. It sounds technical—and it is—but the basics are easy to grasp once you understand what it’s for and why it matters.

Here’s what you need to know

What is a 409A valuation?

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 regulates how companies issue equity (like stock options or restricted stock) to employees and investors.

Think of it as the IRS-approved way to determine what a share of a private company is “worth” for tax purposes.

Why does it exist?

Before 409A rules were enforced, companies had significant discretion in determining the valuation of their equity when issuing stock options to employees. That led to abuse, underpriced options, and tax headaches. So, the Congress created Section 409A to ensure equity grants are based on a reasonable, documented valuation.

Now, if a company wants to offer equity (stock options, RSUs, etc.) to employees or investors, it must get a formal 409A valuation at regular intervals or when major events occur.

How is the 409A valuation calculated?

An independent third-party firm typically performs the valuation. They use a combination of methods, which may include:

• Market approach – comparing the value of the company’s equity to the value of equity in similar public or private companies
  
  
• Income approach – estimating future cash flows and discounting them to today’s value
  
  
• Asset approach – assessing the value of the company’s tangible and intangible assets
  
  

Importantly, 409A valuations only assess the value of common stock—not preferred stock, which is what most VC investors buy. Preferred stock has rights and protections that make it more valuable.

Why is the 409A valuation usually lower than the price investors pay?

Great question. Investors (like VCs) usually buy preferred shares, which come with perks: liquidation preferences, dividends, board seats, etc. Common stock, which employees and some special-purpose-vehicle investors receive, is less valuable due to:

• Lack of liquidity (the holder can’t easily sell it)
  
  
• No control rights
  
  
• Junior position in a liquidation event
  
  

409A valuations reflect these discounts, which is why they’re often much lower than the price paid by institutional investors.

When does a company need a new 409A valuation?

Companies are required to get a new 409A valuation:

• At least every 12 months, or
  
  
• After a material event, such as a fundraising round, acquisition offer, or major change in business model
  
  

Each new 409A sets the “strike price” for employee stock options and can impact how investors value their holdings for tax or accounting purposes.

What does this mean for an investor?

If an investor is holding common stock (or warrants to buy common stock), the 409A can help:

• Understand the paper value of the holder’s shares
  
  
• Estimate the tax basis if the holder is granted or exercising equity
  
  
• Track how the company’s internal valuation is trending over time
  
  

But remember: 409A is not the same as the company’s valuation in a sale or IPO. It’s a conservative, IRS-focused estimate—which may vary from the market price.

Still have questions?
We’re happy to help. Just reach out to cashmere@sweaterfunds.com and we’ll walk you through it.