What a 409A valuation is, what the regulation actually says, and how to choose a provider.

Why section 409A exists

Section 409A was added to the Internal Revenue Code by the American Jobs Creation Act of 2004 and applies to amounts deferred after 31 December 2004. Its subject is nonqualified deferred compensation — arrangements that let someone earn money in one year and be taxed on it later. Congress wanted those arrangements to follow strict rules about when elections are made and when payment occurs.

Stock options landed inside that regime by a side door. An option granted with an exercise price below the fair market value of the underlying stock on the grant date carries built-in value on day one, and the regulations treat that discount as a deferral of compensation. An option granted at or above fair market value, on stock of the service recipient, with no other deferral feature, is generally outside section 409A altogether. So the exercise price is the whole ballgame, and the exercise price depends on a number: fair market value at grant.

What the regulations actually require

It is worth being precise, because a great deal of marketing copy is not. The regulation at 26 CFR § 1.409A-1(b)(5)(iv)(A) says that for stock not readily tradable on an established securities market, fair market value "means a value determined by the reasonable application of a reasonable valuation method". It then lists factors such a method should consider: the value of tangible and intangible assets, the present value of anticipated future cash flows, the market value of comparable public and private entities, recent arm's-length transactions in the stock, and control premiums or discounts for lack of marketability.

Nothing there says "hire a firm". What the regulation adds at subparagraph (B) is a set of presumptions. If your valuation fits one of them, it is presumed reasonable, and the IRS can only overturn it by establishing that the valuation was grossly unreasonable. Without a presumption, the burden runs the other way: you have to show your method was reasonable and reasonably applied.

The practical consequence: the twelve-month rule people quote is the independent-appraisal presumption, and it is conditional. The appraisal supports grants for twelve months from its valuation date, assuming nothing material has changed. A material change resets the clock early, whatever the certificate says on its face.

Who needs one, and when

Any private company granting stock options or stock appreciation rights on its own stock needs a defensible fair market value for the underlying common stock at each grant date. In practice that means a company gets a 409A before its first option grant, and then refreshes it on the earlier of twelve months or the next material event.

How the valuation is actually done

A 409A report has two halves. The first estimates the total equity value of the company. The second allocates that value across the share classes to isolate what a share of common is worth.

The output is a single number: the fair market value per share of common stock. That number is the floor for option strike prices, and it is systematically below the price investors paid for preferred stock in the same company. Why that gap exists, and what makes it wide or narrow, is set out at /equity/fair-market-value. The allocation stage is essentially a waterfall run across many possible exit values — the same machinery described at /equity/exit-waterfall.

What it costs

Publishing a price list for other firms would be inventing numbers, so here is what is actually true about the shape of the market. Pricing varies by an order of magnitude and tracks three things: company complexity, turnaround time, and how much of the work is human.

• Complexity is the main driver. A pre-revenue company with one preferred series and a clean cap table is a fundamentally cheaper appraisal than one with six series, participation rights, warrants, convertible notes outstanding and international subsidiaries.
• Cap table platforms commonly bundle 409A valuations into a subscription, either included at some tier or heavily discounted. That bundling is real and it has reshaped the market — but it also creates a switching cost, because your valuation history lives with the platform.
• Independent valuation firms and accounting firms price as professional services, usually per engagement, and typically cost more than a bundled offering. What you are buying at the top of the market is a report that will survive audit scrutiny and a firm that will stand behind it.
• Audit-stage companies pay more, because the report has to support ASC 718 stock compensation expense and be defensible to the auditors, not just to the IRS.
• Rush turnarounds cost more everywhere. Plan the refresh around your board calendar rather than discovering it the week you want to grant.

Choosing a provider

One vendor-neutral observation. Bundled 409A offerings from cap table platforms are genuinely good value for straightforward companies, and the integration removes a real source of error — the appraiser working from a stale cap table export. The trade is concentration: valuation, cap table and sometimes fund administration in one relationship. For companies with complex structures, an acquisition in view, or an audit, an independent firm is a reasonable premium to pay.