What is it:
A 409A valuation is a formal appraisal that estimates the fair market value of a private company's common stock, performed to satisfy the rules of Section 409A of the Internal Revenue Code. Most venture-backed companies obtain one from an independent, qualified appraiser, and the board approves the result. The valuation is generally relied on for up to 12 months, or until a material event such as a new funding round makes it stale sooner.
Why does it matter:
Tax rules generally require a stock option's strike price to be at least equal to fair market value on the grant date. At a private company, the 409A valuation is how that fair market value is established. A valuation performed by a qualified independent appraiser is presumed reasonable, which protects both the company and its option holders from the significant tax consequences that can follow if a strike price is later found to be below fair market value.
What do people most often get wrong:
People often treat the 409A value as what their equity is worth, or confuse it with the price investors paid in the latest funding round. Investors typically buy preferred stock, which carries rights common stock doesn't, so the 409A value for common stock is usually lower. The 409A value is a defensible reference number for stock option strike pricing, not a market price, a sale price, or a forecast of an IPO.