409A valuation is a method of valuing a stock option, specifically one that meets US Internal Revenue Service (IRS) requirements. These requirements apply for the purpose of dealing with cases in which an employee receives a stock option but does not exercise it in the same financial year. The 409A valuation, named after the relevant section of tax legislation that took effect from 2009, deals with the problem of assessing taxation on an option in such circumstances.
A stock option is a way for a business to reward or pay an employee without handing over cash. Usually it involves a guarantee that at the time of his choice, the employee can buy stock directly from the company at a fixed rate. Clearly this will be most attractive to the employee if the stock's market price rises, as he will be able to exercise the option and sell at an immediate profit. The idea behind the option is that it gives the employee greater incentive to help improve the company's performance. Because of this, stock options are most commonly associated with people in executive positions who theoretically have a greater influence over the company's performance than individual junior-level workers.
As stock options became more popular, accountancy practices changed to find a way of calculating the expense for the company at the time the stock option was issued, as opposed to waiting until the employee exercised the option. This was done through an agreed standard that allowed for a valuation on a fair-value basis, rather than on the face value of the stock. The valuation standard gave companies more flexibility about how to value a stock, but it required them to adopt a consistent method based on both objective and subjective factors. This normally allowed companies to chalk up a greater expense when issuing the stock options, thus reducing taxable profits.
In turn, the fair-value method was adopted by the IRS in dealing with stock options from the perspective of being a benefit to the employee rather than as an expense to the company. Under section 409A of the tax code, most stock options must be valued and listed under the fair market value system used by the employer. While a section 409A valuation can be any that involve the reasonable application of any reasonable valuation method, the IRS has issued guidelines for factors that are expected to be included in a 409A valuation valuation. These include the value of the company's assets, its cashflow forecasts, the market price of stocks in similar companies, and what, if any, constraints are placed on the option.