409A Valuations: What They Are, When You Need One, and What Happens If You Skip It

If you are planning to offer stock options to employees, advisors, or contractors, you need to understand 409A valuations. Not because the topic is exciting. Because getting it wrong creates a tax problem that lands on your team members, not on the company, and cleaning it up is expensive, time-consuming, and entirely avoidable.

Here is how 409A valuations work, when you need one, and what happens when founders skip this step.

What Is a 409A Valuation?

Section 409A of the Internal Revenue Code regulates deferred compensation. Stock options get a special exception from 409A's rules, but only if two conditions are met:

1. The exercise price is set at no less than fair market value (FMV) on the grant date.
2. The options do not contain deferral features like liquidation preferences or put/call rights above FMV.

A 409A valuation is a formal, independent appraisal of your company's common stock that establishes FMV. The IRS provides a "safe harbor" for this: if the valuation is conducted by a qualified independent third-party firm, and the board relies on it to set the exercise price, the company is protected.

What Does Not Count as a Valid Valuation

Founders sometimes assume they can estimate the value themselves. They cannot. The IRS is specific about what qualifies for safe harbor protection, and the following do not:

• A discount to the last preferred round price
• A two-page report from your CPA or CFO
• A "rule of thumb" like one-tenth of the preferred price
• An internal management estimate

If your valuation does not come from a qualified independent firm and follow the IRS methodology, you do not have safe harbor protection. That means the burden shifts to you to prove the exercise price was at FMV, which is a much harder position to be in.

When You Need a 409A

The simple rule: get a 409A before your first option grant. After that, update it at least annually.

But the 12-month clock is not the only trigger. A 409A can go "stale" before its expiration date if a material event occurs. Material events include:

• Signing a term sheet for a capital raise (equity, SAFE, or debt)
• Closing a financing round
• Receiving an acquisition offer (solicited or unsolicited)
• Launching a new product
• Executing a material contract
• Significant changes in revenue forecasts or operational metrics
• Completing secondary sale transactions

Even rejected offers or abandoned transactions can be material. The question is whether the event changes the assumptions the valuation firm relied on. If it does, you need a new valuation before granting options.

What Happens Without a Valid 409A

This is where it gets serious. If options are determined to have been granted below FMV, the consequences fall primarily on the option holders, not the company:

• Income taxes on the full spread of the vested portion each year, even without exercising
• 20% federal penalty tax on top of ordinary income tax
• 5% California penalty (if applicable)
• Taxes owed even though the employee has no liquidity to pay them

The company is not off the hook either. It must withhold these amounts, report the failure to the IRS, and deal with the fallout.

During a financing or acquisition, 409A problems get magnified. Investors and acquirers scrutinize option grant compliance because:

• Penalties can exceed the option spread by the time of exercise
• Cleanup is expensive in money, time, and team morale
• It may result in "cheap stock" accounting charges
• It can delay or derail financings, M&A, or IPOs

What About Non-US Team Members?

Many startups, especially Fellow clients, are structured as Delaware C-Corps with founders and team members entirely outside the United States. A common question: do you still need a 409A if none of your option holders are US taxpayers?

The short answer: Section 409A penalties only apply to individuals subject to US income tax. If an option recipient is not a US citizen, green card holder, or tax resident, performs no services while physically in the US, and has no plans to relocate, the 409A exercise price requirement is not a tax concern for that person.

But that does not mean you can skip the valuation entirely. There are several reasons to get one anyway:

• Your stock plan probably requires it. Most standard stock plans contain language requiring all NSO exercise prices to be set at no less than 100% of FMV, regardless of where the recipient lives. Granting below FMV would violate the plan terms.
• Investor documents may require it. SAFEs, convertible notes, and preferred stock financing documents sometimes contain covenants requiring compliant equity practices.
• Transaction readiness. Investors and acquirers review 409A compliance across all option grants during due diligence. Missing valuations raise flags.
• Future US hires. The moment you grant options to a US person, you need a valid 409A. Having a consistent history of FMV-based grants is cleaner than explaining pricing discrepancies.
• Relocation risk. If a foreign recipient moves to the US, previously granted below-FMV options become a latent 409A problem.

How Much Does It Cost?

Less than you think, especially relative to the cost of getting it wrong.

• Early-stage with a simple cap table: Under $2,000
• Carta or Pulley subscribers: Often included free or at low cost
• Complex cap tables (multiple preferred classes, debt instruments): $2,000 to $5,000

Providers to consider include Carta, Pulley, Scalar, Oxford Valuation Partners, Redwood Valuation, and Teknos Associates.

Common Questions

Do we need a 409A before sending an offer letter with stock options?

No. A promise to grant options in an offer letter is not the actual grant. You need the valuation on the actual grant date, which is typically at the next board meeting. Pro tip: never specify a price per share in the offer letter. Say "at the fair market value to be determined by the Board of Directors on the grant date."

Our last 409A is 11 months old. Can we still use it?

Possibly, but be careful. The board's determination must reflect all information known at the time of grant. If material events have occurred since the valuation, you may need a new one. Be especially cautious about granting options in November or December. If you rely on a valuation from the prior year and the new valuation comes in higher, you could end up with discounted options and no easy fix.

Will investors think our enterprise value is too low?

No. Sophisticated investors understand that 409A valuations use tax code rules, not VC valuation methodologies. They apply discounts for liquidation preferences, lack of marketability, and lack of control. These are purely for stock plan administration. In fact, investors want to see 409A compliance. It signals sophisticated management.

The Bottom Line

A 409A valuation is one of those things that feels like overhead until you need it. And by the time you need it, it is too late to go back and fix it.

Get your first 409A before your first option grant. Update it annually and after material events. Do not grant options in the window around a financing. And when in doubt, ask before you grant.

The cost of a 409A is a few thousand dollars. The cost of not having one can be a derailed fundraise, a tax nightmare for your team, or a deal that falls apart in due diligence.