A 409A valuation (name arising from Section 409A of the United States Internal Revenue Code) is an assessment of the fair market value (FMV) of a private company’s common stock. Common stock are reserved for founders and employees. It should ideally be determined by an independent third party such as Carta. The valuation is valid for a maximum of 12 months or until a “material event” occurs.

The material event could include new debt/equity financing, an offer of merger or acquisition, or an approaching IPO. You should also get the 409A valuation before you issue your first common stock options (ESOPs).

There are mainly three steps involved -

  1. Calculating the value of the company/startup.
  2. Identifying the value of the common stock (more on this below)
  3. Applying a discount factor for lack of marketability (DLOM), that is since the company is not being publicly traded on a financial exchange, it is much more difficult to buy and sell shares and hence the decrease in the value as compared to a public company. A startup that has just raised seed/Series A will have a large DLOM as compared to an established startup in later stages.

As discussed above, common stock are reserved for founders and employees. Then, there are preferred stocks, usually held by investors. These shares have superior rights (liquidation preference, participation, etc.). Thus, the value of the preferred stock is usually higher than the common stock. The next question would be how do we come up with this value of common stock then or what’s the typical ratio of preferred to common stock. We will cover this is in a subsequent post.