Why Does a 409A Valuation Rise as a Startup Nears an Exit?

A 409A valuation is the price a private company sets on one share of common stock, so that options granted at or above it escape a 20% federal penalty tax. The price sits below what investors paid for preferred stock, and the gap measures how far away an exit is: it closes as one approaches.

Eloqua, a marketing-automation software company, shows the gap closing in its own IPO filing. Its board granted options at $1.20 a share in January 2009 and at $9.03 in July 2012, 29 days before its prospectus priced the shares at $11.50. Between those grants, the weight its independent valuer gave to an IPO rose from 5% to 45%. The rules tighten in step: the cheapest route to a defensible 409A valuation closes as an exit nears, and every grant becomes evidence that the SEC, an acquirer or the IRS may read.

Four routes to a defensible 409A valuation, and what each one buys

Route	Who values the stock	Conditions	What it buys
Any reasonable method	Anyone, including the board	Weighs assets, cash flows, comparable companies, recent sales of the stock and marketability; reflects all material information; no more than 12 months old	Compliance, if the company can prove it
Independent appraisal	An appraiser who meets the ESOP independence test of §401(a)(28)(C)	Valuation date no more than 12 months before the grant	A presumption: the IRS must show the method or its application was grossly unreasonable
Binding formula	A formula price valid under the §83 rules	Used for every transfer to the company or to holders of more than 10% of the vote	The same presumption
Illiquid start-up	A qualified person, generally with 5 years’ relevant experience	Written report; business under 10 years old; no publicly traded equity; no sale expected within 90 days and no IPO within 180 days	The same presumption

Source: Treas. Reg. §1.409A-1(b)(5)(iv)(B); Treasury and IRS, T.D. 9321 preamble (2007); 26 U.S.C. §401(a)(28)(C).

Who sets a 409A valuation, and does it need an appraiser?

The board sets it, and no appraiser is required. Section 409A, added to the tax code on 22 October 2004 (26 U.S.C. §409A), punishes deferred compensation that breaks its rules. Everything deferred “for the taxable year and all preceding taxable years” becomes taxable once vested, with an additional tax of 20% and interest at the underpayment rate plus 1 percentage point. A stock option stays outside those rules only if its exercise price “may never be less than the fair market value of the underlying stock” on the grant date (Treas. Reg. §1.409A-1).

For a private company, fair market value means “a value determined by the reasonable application of a reasonable valuation method”, judged on “the facts and circumstances as of the valuation date”. The company’s consistent use of the same method for other purposes, including ones unrelated to pay, counts in the method’s favour. When Treasury finalised the rules in April 2007, it wrote that “it is not necessary that a taxpayer demonstrate that the value was determined by an independent appraiser” (T.D. 9321, 72 FR 19234). What an appraisal buys is a presumption. Use one of the three presumption methods in the table above and the IRS can overturn the value only by showing that the method, or its application, was grossly unreasonable. The appraiser’s independence is judged by the test written for employee stock ownership plans (26 U.S.C. §401(a)(28)(C)).

The decision stays with the board. Eloqua’s prospectus states the duty: “our board of directors is required to estimate the fair value of our common stock at the time of each grant of stock-based awards” (Eloqua, 2012). Treasury also refused to import the incentive-stock-option rule under which a good-faith attempt at fair market value rescues an underpriced option: “no such provisions exist within section 409A or its legislative history”. The statute taxes the person who holds the option, so the employee pays for an error made in the boardroom.

Why is the 409A price lower than the preferred price?

Because a sale repays preferred stock first, and common stock gets what is left. Fischer Black and Myron Scholes saw the structure in 1973: “almost all corporate liabilities can be viewed as combinations of options”, common stock included (Black & Scholes, 1973). Common stock is a call option on the company, struck at the preference stack, and the option-pricing method used most often for venture-backed companies values it that way (Moon, 2020). Three inputs to that calculation shrink as an exit approaches.

The first is risk. The AICPA’s valuation guide, in its December 2025 working draft, reprints James Plummer’s 1987 target returns for venture investors: 50% to 70% a year for a start-up, 25% to 35% at the bridge-to-IPO stage (AICPA, 2025). Targets set almost 40 years ago show the direction better than today’s rate. As a company meets its milestones, the guide says, “the target rates of return for an investment in an enterprise would likely decline”.

The second is time, priced as a discount for lack of marketability (DLOM): the cut for shares that cannot be sold. Studies of restricted public stock find median discounts of 13% to 45%; studies comparing private prices with later IPO prices found averages of 21% to 66% between 1980 and 2002, although they track only IPOs that happened.

The models now most used make the discount a function of time; in the Finnerty model, discounts “increase roughly proportionately to the square root of the duration of the restriction”. The square root is the signature of a random walk, whose expected distance from its start grows with the square root of the number of steps (Random walk). On that model, at a given volatility, a company two years from an exit carries about 71% of the marketability discount of one four years away (our arithmetic). Volatility rarely holds still, and the guide finds it higher in smaller, riskier companies; that suggests, without proving it for any one company, a discount that narrows faster than the square root implies.

The third is the chance that the preferred stock’s rights matter at all. In an IPO the preferred converts to common and the preferences disappear; in a sale at or below the preferences, common receives nothing. As the probability of an IPO rises, the common price moves toward the preferred price.

How did Eloqua’s 409A price move before its IPO?

It rose 7.5 times in three and a half years, to 79% of the IPO price. Eloqua’s August 2012 prospectus sets out all 22 option grants from January 2009 onwards, with the independent valuer’s figure behind each. The valuer, Timan LLC, used a probability-weighted expected return method (PWERM) across four scenarios: an IPO, a sale, liquidation and staying private.

Eloqua’s common stock rose from 10% to 79% of its IPO price as the IPO weight rose from 5% to 45%

Valuation date	IPO weight	Liquidation weight	Valuer’s figure	Board’s exercise price	Board’s price as % of the $11.50 IPO price
30 Nov 2008	5%	25%	$1.20	$1.20	10%
31 Aug 2010	5%	25%	$2.33	$2.33	20%
28 Feb 2011	5%	25%	$3.25	$4.75	41%
30 Jun 2011	40%	10%	$7.15	$7.15	62%
22 Aug 2011	40%	10%	$6.33	$7.25	63%
17 Jan 2012	40%	10%	$8.13	$8.13	71%
28 Jun 2012	45%	5%	$8.59	$9.03	79%
IPO, 1 Aug 2012				$11.50 offering price	100%

Source: Eloqua, Inc., prospectus (Form 424(b)(4)), 1 August 2012, discussion of the fair value of common stock. Seven of 22 grant dates shown. The IPO weight adds the report’s IPO scenarios; percentages of the IPO price are our arithmetic.

The valuer held its discount rate at 35% for every scenario, the top of the guide’s bridge-to-IPO range, so the movement came from the scenario weights and the business. Part of it had nothing to do with the exit. The filing attributes the rise to $3.23 in February 2011 “in large part to an increase in the market-based valuation of comparable public companies”, and later rises partly to “revised internal operating forecasts”.

The IPO price stood 27% above the last grant. Eloqua explained why: the offering price “excludes the marketability or illiquidity discounts associated with the timing or likelihood of an initial public offering, the superior rights and preferences of our preferred stock and the alternative scenarios”. That sentence names all three forces. Eloqua is one company, though, and its path mixes the distance to an exit with comparables and forecasts: it shows the mechanism, not a typical ratio at a given distance from an IPO.

How often does a startup need a new 409A valuation?

At least every 12 months, and sooner after material news. An early-stage report costs “in the low thousands of dollars”, according to one provider, Morgan Stanley at Work (Morgan Stanley at Work). Near an exit, three things tighten. The first is the start-up method, the cheapest route to the presumption, which stops applying once the company can reasonably anticipate a sale within 90 days or an IPO within 180 (Treasury’s 2005 proposal had used 12 months).

The second is the date. An old figure becomes unreasonable once it “fails to reflect information available after the date of the calculation”, such as the resolution of material litigation or the issue of a patent. German has an exact word for such a date: Stichtag, a fixed day that governs a calculation (our translation of Duden). Eloqua’s valuer reported as of 17 January, 27 March, 25 April and 28 June 2012, a new figure every one to three months in the company’s last private year.

Between reports, Eloqua’s board priced above its valuer. In April 2011 it granted at $4.75 against a report of $3.25 as of 28 February, citing “the significantly increased likelihood that we would be able to complete an initial public offering in 2011”. In August 2011 it held $7.25 when the new report said $6.33. On 5 of 22 grant dates the board’s price exceeded the valuer’s latest figure, by up to 46% (our arithmetic). The regulation sets a floor on the exercise price and no ceiling.

The third is the reader. Before an IPO, SEC staff ask companies to “explain the reasons for any differences between the recent valuations of your common stock leading up to the initial public offering and the estimated offering price”. A June 2021 letter to Graphite Bio is one example (SEC, 2021). The AICPA guide calls a large shortfall cheap stock and tells companies to “be prepared to reconcile the change in the estimated fair value” between each grant date and the offering price. Eloqua answered in one table.

What happens if options are granted below fair market value?

The holder is taxed on the whole year-end spread, and only a quick reset prevents it. On 26 December 2003 Marvell’s compensation committee, made up solely of independent directors, approved an option for its chief executive, Sehat Sutardja, over 1.5 million shares at $36.50, that day’s closing price. The committee ratified it on 16 January 2004, when the stock closed at $43.64, and an internal review later took the ratification date as the measurement date. The IRS applied §409A to Sutardja’s 2006 exercises, with $5,282,125 in dispute. In February 2013 the Court of Federal Claims decided the legal questions for the government and left for trial whether the option had in fact been discounted (Sutardja v. United States, 2013).

On the government’s case, 21 days of paperwork turned a market price into a discount of $7.14 a share before splits (our arithmetic). The tax base is larger still. Under proposed regulations published in December 2008, the amount deferred under an outstanding option is its spread at year end: the stock’s fair market value less the exercise price. A holder “generally will be required to include amounts in income under section 409A in more than one taxable year” (73 FR 74380).

A 20-cent discount taxed on a $3.00 spread, for a hypothetical employee

	Per share	10,000 vested options
Exercise price set by the board	$1.00
Fair market value at grant, as the IRS later finds	$1.20
Discount at grant	$0.20	$2,000
Fair market value at the end of the year of vesting	$4.00
Amount includible in income (year-end spread)	$3.00	$30,000
Additional tax at 20%	$0.60	$6,000
Cost of a same-year reset to $1.20 under Notice 2008-113	$0.20	$2,000

Source: our calculation for a hypothetical employee and company, following the 2008 proposed regulations. Ordinary income tax on the $30,000 and premium interest come on top.

The additional tax alone is three times the original discount, payable in cash on shares the employee may be unable to sell. IRS Notice 2008-113 offers a repair for an option priced below fair market value by error. If the company resets the exercise price to at least the grant-date value before exercise and by the end of the employee’s tax year of grant, the notice treats the option as outside §409A from the day of grant (IRS, 2008). For employees who are not insiders, the deadline runs to the end of the following year.

Can the 409A discount be compared across companies?

Valuers say it cannot. Bob Chung, director of valuations at Carta, told a16z that “the ratio is highly dependent on a given company’s ability to negotiate favorable financing terms at a specific point in time. It can’t be applied as a benchmark across a range of disparate companies” (Moon, 2020). The AICPA guide calls percentage-of-preferred rules of thumb “inappropriate because they are difficult to substantiate objectively”.

Chung’s point about financing terms settles the comparison. Two hypothetical companies with common prices at 30% and 50% of their preferred prices may differ only in participation rights, preference stacks or valuation methods. The gap says nothing about which one is nearer an exit. A board that sets a 409A valuation as a fixed share of the preferred price has no method to defend and forfeits the presumption.

Within one company, with its preference terms unchanged, the ratio’s movement between two reports does carry information: a scenario weight, the discount rate, the DLOM or the business has moved, and the valuer can say which. That is the question SEC staff ask before an IPO.

Read that way, a 409A valuation is the board’s judgement of what a share of common stock was worth on one date. Its discount to the preferred price mostly measures time and doubt: how far away the exit is, and how likely it is to happen. As the exit nears, the 409A valuation climbs, the start-up method falls away and each grant becomes a figure the company may have to reconcile with its offering price.

Notes and sources

• American Institute of CPAs, Financial Reporting Executive Committee (2025). Valuation of Privately-Held-Company Equity Securities Issued as Compensation, working draft of the updated Accounting and Valuation Guide, 18 December 2025.
• Black, F. and Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy 81(3), 637–654.
• Duden. Stichtag.
• Eloqua, Inc. (2012). Prospectus, Form 424(b)(4), 1 August 2012. SEC EDGAR.
• Internal Revenue Service (2008). Notice 2008-113.
• Moon, C. (2020). 16 things to know about the 409A valuation. Andreessen Horowitz.
• Morgan Stanley at Work. 409A Valuation FAQ and Guide.
• Securities and Exchange Commission, Division of Corporation Finance (2021). Comment letter to Graphite Bio, Inc., 7 June 2021.
• Sutardja v. United States, 109 Fed. Cl. 358 (2013).
• Treasury Department and IRS (2007). Application of Section 409A to Nonqualified Deferred Compensation Plans, T.D. 9321, 72 FR 19234.
• Treasury Department and IRS (2008). Further Guidance on the Application of Section 409A to Nonqualified Deferred Compensation Plans (proposed regulations), 73 FR 74380.
• Treas. Reg. §1.409A-1 (26 CFR 1.409A-1), via eCFR.
• 26 U.S.C. §§401(a)(28)(C), 409A and 422, via Cornell’s Legal Information Institute.
• Wikipedia. Random walk.

The figures come from the statute, the regulations, Eloqua’s prospectus, the AICPA guide in its December 2025 working draft and the 2013 Sutardja opinion, whose facts are as the parties stated them rather than findings of the court. Figures given without a source are our own calculation from the cited numbers; the IPO weights in the Eloqua table, for instance, add the filing’s IPO scenarios. The 20-cent example is a hypothetical built on the 2008 proposed regulations, and the translation from German is ours. The piece describes US federal tax rules and offers no tax advice.