Every startup carries at least two valuations at once: the headline number you negotiated with investors, and the number a valuation firm assigns to one share of your common stock so you can grant options legally. Founders who conflate the two either overpay employees' taxes or walk into an IRS problem. This is the 409A valuation explained the way an operator needs it: what the number is, where it comes from, when it expires, and what it's called outside the US.
This lesson assumes you know what a priced round is and how price per share is computed. If not, start with priced rounds and term sheets.
Enterprise value vs per-share value
When someone says "the company is worth $15M," they mean enterprise value (for an early-stage startup with no debt, effectively the value of all the equity combined). When your lawyer asks for "the FMV," they mean per-share value: what one specific share of one specific class is worth today.
The naive conversion is a division: $15M across 10,000,000 fully diluted shares is $1.50 a share. That division is roughly right for the preferred shares your investors just bought. It is wrong for common, and the gap between the two is not a loophole or an accounting trick. It's real economics, and it's the next section.
Keep the two numbers in separate mental columns. Investors negotiate the first. Your employees' option strike prices hang off the second, and the second also moves with the structure sitting above common in the stack: preferences, participation, seniority.
Why common is worth less than preferred
Preferred stock is common stock plus a contract, as covered in share classes: common vs preferred. The contract's core term, the liquidation preference, means preferred holders get paid before common in a sale. So in every downside scenario, preferred shares are worth more than common shares. Only in strong exits do the two converge.
Worked example: the same company, two per-share values
Post-money $15M: an investor paid $3M for 2,000,000 preferred shares at $1.50, with a 1× non-participating preference. Founders and the pool hold the other 8,000,000 shares as common. Now run two exits.
Sale at $30M: preferred converts (20% × 30M = $6M beats the $3M preference). Everyone gets $3.00 a share. Common and preferred are equal.
Sale at $6M: preferred takes its $3M preference off the top. Common splits the remaining $3M across 8,000,000 shares = $0.375 a share, while the preferred effectively realized $1.50. The naive division ($6M ÷ 10M = $0.60) was wrong for everyone.
A share of common is a claim on the leftovers in bad outcomes and an equal claim in great ones. Average across the whole range of possible futures and one common share must be worth less than one preferred share, at an early stage often much less. A valuation firm modeling this company might land on a common FMV of $0.45: 30% of the preferred price.
Valuation firms make this rigorous with an option-pricing model (OPM): each share class is treated as a claim on a distribution of exit values, often "backsolving" enterprise value from what your last round's investors actually paid, then applying a discount for lack of marketability (DLOM), commonly 20–35%, because a share you can't sell is worth less than the model's theoretical value. Early-stage common FMV typically lands between 20% and 50% of the last preferred price, drifting upward as the company matures toward an exit.
That gap is good news for employees: it means options can carry a strike of $0.45 while investors pay $1.50, giving new hires built-in upside on day one, legally.
What a 409A valuation actually is
Section 409A of the US Internal Revenue Code governs deferred compensation, and stock options priced below fair market value on the grant date fall under it, with ugly tax consequences (below). So US companies must be able to show that every option's strike price was at least the FMV of common on the day it was granted.
A 409A valuation is an independent appraisal of that FMV. Its legal value is the safe harbor: if the valuation is performed by a qualified independent appraiser, the IRS must accept it unless it can show the number was "grossly unreasonable." The burden of proof flips from you to them. (A do-it-yourself presumption exists for illiquid startups, but almost nobody relies on it; the independent report is cheap insurance by comparison.)
Be precise about what the document is: a report from a valuation provider stating the FMV of one common share as of a specific date, which your board relies on when approving grants. It is not produced by your lawyer, your accountant, or a spreadsheet. It comes from a qualified appraisal practice, whether you engage a firm directly or through a platform that bundles one.
Why founders don't wing it. If the IRS later decides options were granted below FMV, Section 409A taxes the employee, not the company, on the spread as it vests, adds a 20% additional federal tax plus interest, and some states pile their own penalty on top. A safe-harbor report that costs a few thousand dollars protects every option holder on your team from that outcome. It's one of the cheapest pieces of risk removal in startup finance.
When you need one: the 12-month clock and material events
A 409A valuation is reliable for the earlier of two endpoints:
- 12 months from the valuation date; or
- a material event, anything that clearly changes the company's value. A new priced round is the canonical one; a signed term sheet, an acquisition offer, a transformative contract, or losing a major customer can all qualify.
In practice: get your first 409A before the first option grant, refresh it every 12 months, and refresh it after every priced round. Between those, your board can keep granting at the last reported FMV.
Worked example: a material event resets the clock (and the strike)
Your 409A is dated Feb 1, 2026 with a common FMV of $0.45, reliable through Jan 31, 2027 if nothing happens. In September 2026 you sign a Series A term sheet at $4.00 per preferred share; the round closes Oct 15.
Grants your board approved in the spring and summer at $0.45 are fine. But the round is a material event: the February report can no longer be relied on, and the post-round refresh comes back at $1.20.
A hire who joined in September but whose grant wasn't approved until November gets 25,000 options struck at $1.20 instead of $0.45. Exercising will cost them 25,000 × ($1.20 − $0.45) = $18,750 more, and more of their eventual gain lands as taxable spread. Same job offer, same option count; the only difference was grant timing versus the valuation calendar.
Two operational lessons fall out of that example. First, run board approvals for pending grants before a term sheet is signed when the grants were already planned. That is legitimate and routine; inventing grants to sneak under an old FMV is not. Second, order the refreshed 409A as soon as the round closes, because you cannot cleanly grant until the new number arrives. Grant mechanics are covered in granting options the right way.
Outside the US: FMV Assessment (UK) and Valuation Report (India)
The 409A is a US construct, but the underlying question (what is one common share worth, defensibly, today) exists everywhere options are granted. The paperwork differs.
United Kingdom. For tax-advantaged EMI option schemes, companies typically agree a valuation with HMRC in advance (an FMV assessment). The striking difference from the US is the window: an agreed EMI valuation is generally valid for around 120 days, not 12 months, so UK companies batch their grants inside the window rather than granting continuously all year. Check current HMRC guidance for the exact window before relying on it.
India. Share issuances and ESOP tax events lean on a Valuation Report from a SEBI-registered merchant banker or a registered valuer, depending on the purpose (Companies Act issuances, income-tax Rule 11UA pricing, ESOP perquisite valuation). Reports here are also short-lived (for several purposes they must be recent, on the order of a few months), and the "who is allowed to sign" question matters as much as the number.
The operator's takeaway is the same in all three markets: an independent per-share valuation with a defined shelf life gates your option grants. Only the label, the issuer, and the clock length change. The regional equity differences lesson covers what else shifts across borders.
What the valuation firm needs from you
A 409A engagement is mostly a document hand-off plus a management call. Expect to provide:
- Your current cap table, fully diluted: every class, every option, every SAFE and warrant.
- Financing documents for the last round: stock purchase agreement, charter with the preference terms.
- Historical and projected financials, even a simple operating model. Pre-revenue is fine, say so.
- Articles/charter, board composition, and any acquisition offers or term sheets received.
- A management questionnaire: what the company does, the team, the market, known risks.
Turnaround is typically one to three weeks, and the biggest driver of a smooth engagement is clean inputs: a cap table that reconciles and a folder where the charter, SPA, and prior reports are actually findable.
Tracking validity so it never bites
Once the report lands, it becomes two dates and a number: the valuation date, the FMV, and the day the clock runs out. Then it has to survive contact with real life: a term sheet in month seven, a grant batch in month eleven, a board asking "are we still inside the 409A?" mid-meeting.
This is the part software genuinely helps with, and the honest division of labor is simple: valuation providers deliver the number; tools track it. Vquity's valuations module logs each 409A/FMV with its dates, alerts you before the 12-month clock expires, and keeps a recalculation and rollback audit trail so every grant can point at the report that was in force when it was approved. What Vquity doesn't do is produce the appraisal itself. Some platforms bundle a valuation service, but the safe-harbor report always comes from an appraisal engagement, and in Vquity's case that engagement is yours, with an independent firm.
Wire the same discipline into hiring: offer letters should promise an option count, never a strike price, because the strike is whatever the FMV is on the board-approval date, a number you can't guarantee months ahead.
You now have valuation in both senses: the enterprise number investors negotiate and the per-share number that prices your options. The last piece of fundraising math is what happens when the company is sold, and how preferences, caps, and seniority slice an exit. That's next: liquidation waterfalls.