What is the 409A valuation requirement for IRS purposes?

For a typical private-company stock option, the IRS-facing requirement is that the exercise price be at least the fair market value of the underlying common stock on the grant date. The value must come from the reasonable application of a reasonable valuation method using the material facts available at that time.

The regulations point to factors such as:

• Tangible and intangible assets
• Expected future cash flows
• Comparable public companies or transactions
• Recent arm's-length transactions in the company's own equity
• Control rights and the lack of marketability
• Any other information material to the company's value

The IRS does not issue a certificate approving your report. Your board adopts the value, and the file needs to show why that conclusion was reasonable on the date of the grant.

An independent appraisal dated no more than 12 months before the relevant grant can create a presumption of reasonableness. That presumption can end earlier if later information materially affects value. With the safe harbor, the IRS would have to show that the method or its application was grossly unreasonable to rebut the presumption.

Without safe harbor, the company can still argue that its FMV was reasonable, but it starts without that favorable presumption. That is a proof problem you do not want to discover during an examination or transaction.

The distinction is explained in whether a 409A is legally required and how safe harbor shifts the burden. For the full valuation and documentation flow, use the founder's guide.