What happens if you skip getting a 409A valuation?

If you skip a 409A valuation and issue stock options anyway, here's what happens: your employees become personally liable for a 20% excise tax penalty on top of accelerated income recognition.

In other words, the penalty is not on your company: it's on the people you were trying to reward.

"The penalties are actually on the employee, the participant — not the company or the employer. Under 409A, if you violate those rules, it's actually a 20% excise tax penalty payable by the employee."
— Matt Secrist, Partner at Taft Law

That's the direct answer. Everything below is the full picture: when it hits, how it compounds, and what founders commonly get wrong when they decide to delay.

The direct consequences: employee-level, not company-level

Most founders who delay a 409A assume the downside is a compliance headache, something they'll clean up before exit. The actual exposure is more immediate and more personal than that.

Under IRS Section 409A, if you issue stock options at a strike price below the fair market value (FMV) of your common stock (or you issue options without a defensible FMV at all), those options are treated as "discounted options." Discounted options trigger two consequences for every employee who holds them:

• ‍Accelerated income recognition. The employee must recognise the difference between the option's exercise price and the FMV as ordinary income, even if they haven't exercised the option or received any cash. They're taxed on paper gains they can't yet realise.‍
• 20% excise tax. On top of income tax, the employee owes an additional 20% excise tax under Section 409A.

The company isn't exempt from all consequence, but the direct financial penalties are carried by the employee. That's the part most founders don't fully grasp until it's too late.

When the exposure triggers: at vesting, not at exit

This is where the timing misconception causes the most damage.

Founders often assume that even if there's a compliance issue, it'll surface at exercise or exit, when employees are actually selling shares and have cash in hand to cover any tax liability. That's not how Section 409A works.

The exposure triggers at vesting. The moment a non-compliant option vests, the employee faces the income recognition obligation. They don't need to have exercised anything. They don't need to have received any proceeds. The taxable event is the vesting of the option itself.

For most early-stage employees, that means a tax bill on paper gains from shares they can't yet sell. The outcome you were trying to create (a meaningful equity stake that rewards people as the company grows) becomes a tax liability instead.

The double hit: accelerated income recognition and 20% excise tax, explained

Here's what the penalty actually looks like in practice.

Suppose an employee has options with a strike price of $1.00, and the FMV at the time they vest is $5.00. Because the options were issued without a compliant 409A, they're treated as discounted compensation. At vesting:

• The employee must recognise $4.00 per option as ordinary income (the spread between strike price and FMV).
• They then owe their marginal income tax rate on that $4.00, before they've exercised a single option.
• They also owe a 20% excise tax on the same $4.00.

So on a 10,000-option grant, the employee could face a tax bill based on $40,000 of recognised income, plus an additional $8,000 in excise tax, all before seeing any proceeds from the equity itself.

Steve Allan of Allanytics, who has completed over 10,000 valuations, puts it plainly:

"Getting the 409A valuation right is one of the most impactful things you can do for the people joining your company."
— Steve Allan, Founder of Allanytics

The inverse is equally true: getting it wrong turns your equity offer into a financial burden for the people it was supposed to benefit.

Common misconceptions founders rely on

"We're too small to be audited"

Most 409A non-compliance doesn't surface in an IRS audit. It surfaces in M&A due diligence.

When a potential acquirer reviews your equity structure, their counsel will look at every option grant: the strike price, the 409A report backing it up, and whether a compliant valuation was in place at the time of grant. If there isn't a clean, timestamped 409A for every grant cycle, the issue gets flagged. That finding doesn't just affect the company's liability: it affects your employees' position in the deal, and it can delay or complicate the transaction entirely.

The IRS audit risk is real but slow. Acquisition due diligence is fast, thorough, and happens exactly when you can least afford complications.

"We'll fix it before exit"

There's no simple retroactive fix for a non-compliant 409A. Once options have been granted at an incorrect strike price (or without a 409A in place), the exposure already exists for the employees who hold them. Correcting the strike price going forward doesn't erase the liability on grants already made.

Some practitioners may point to correction programs (including the IRS's own correction guidance), but these are narrow in scope, fact-specific, and not a reliable clean-up path. They require legal counsel, can involve their own tax consequences, and aren't available for all violation types.

"We can backdate it"

Backdating a 409A report (or treating a later valuation as if it were in place at the time of an earlier grant) is not a viable strategy. A compliant 409A needs to be in place before the option grant date. The timestamp on the valuation report matters. Appraisers and legal counsel will flag any attempt to backdate, and the resulting exposure is the same as having no 409A at all.

"This only matters for large option pools or later-stage companies"

Section 409A applies to every option grant, from the first hire at pre-seed through to Series C. There's no de minimis exemption. Whether you've granted 1,000 options or 1,000,000, the obligation is the same: a defensible FMV in place before the grant date.

How the IRS discovers non-compliance

The most common discovery path is not a random audit: it's acquisition due diligence.

When a company is acquired, the buyer's legal team reviews the equity structure as part of the deal process. If they find option grants without a matching 409A, or grants where the strike price appears inconsistent with the FMV at the time, that surfaces as a material finding. The acquisition may be restructured, the purchase price adjusted, or the deal slowed while the issue is assessed.

Employees who are expecting a clean equity payout at exit may find their options reclassified or their tax position complicated by prior non-compliance, through no fault of their own.

Secondary discovery paths include:

• ‍Employee complaints. If an employee exercises options and encounters a tax situation they weren't expecting, they or their accountant may raise questions that trigger further scrutiny.‍
• Investor due diligence. Investors conducting diligence for a priced round review equity documentation as standard. Non-compliant grants can affect your ability to close a round cleanly.‍
• Auditor review. If your company undergoes a financial audit, the auditor will review equity grant documentation and flag any grants without supporting 409A reports.

What clean looks like

A compliant 409A structure means one thing: a defensible, timestamped valuation from a qualified independent appraiser in place before every option grant cycle.

The specific conditions for clean compliance:

• A 409A valuation completed before your first option grants, regardless of stage
• A fresh valuation after each priced funding round closes (or when a term sheet is signed, as many practitioners treat this as a material event)
• Annual refresh if no material event has occurred and your 12-month clock is running
• A new valuation after any material change: significant ARR movement, a major contract, or an approaching IPO, merger, or acquisition

See our guide to 409A valuation triggers for the full list of events that require a fresh valuation.

The 409A Valuation Checklist maps each trigger to the timing and documents you'll need.

A clean 409A isn't just about avoiding penalties. As Steve Allan explains, it functions as "an HR tool" designed specifically to help employees participate in the upside. A lower, defensible 409A FMV means a lower strike price on every option you grant. That's a direct benefit to the people joining your company, and it's only available if the 409A is done properly and on time.

For more on how the 409A interacts with your equity programme, see our guides to startup stock options and 409A valuation costs.