← Back to Insights Audit Q&A

409A Valuation Audit Support

What auditors look for in equity compensation valuations and how to document defensible assumptions under Section 409A and ASC 718.

Section 409A of the Internal Revenue Code requires that stock options be granted at no less than fair market value to avoid immediate taxation and penalties. For private companies, this means obtaining an independent valuation—a 409A valuation—that auditors will scrutinize during their review of equity compensation under ASC 718.

Understanding what auditors look for in 409A valuations allows you to build defensibility into the work product from the start.

The Audit Focus Areas

1. Valuation Methodology Selection

What auditors examine: Is the methodology appropriate for the company's stage and circumstances?

For early-stage companies, auditors expect to see:

• Option Pricing Method (OPM) or Probability-Weighted Expected Return Method (PWERM) for complex capital structures
• Clear rationale for method selection documented in the report
• Consideration of recent financing rounds and their implications

The FairvalueX approach: We document methodology selection in a dedicated section, explaining why the chosen method is appropriate given the company's stage, capital structure complexity, and proximity to liquidity events.

2. Volatility Assumption

What auditors examine: How was volatility determined, and is it supportable?

Volatility is one of the most sensitive inputs in option pricing. Auditors look for:

• Guideline public company volatility data with selection criteria
• Consideration of the company's specific risk factors
• Appropriate lookback period matching expected option term
• Blending methodology if using multiple comparables

The FairvalueX approach: Our volatility analysis includes a Comparable Selection Matrix showing each guideline company, its characteristics, and why it was included or excluded. Historical volatility calculations are shown at multiple time horizons, and the selected volatility ties to the expected term.

3. Discount for Lack of Marketability (DLOM)

What auditors examine: Is the DLOM analytically derived rather than rule-of-thumb?

Auditors have zero tolerance for "industry standard" discounts without support. They expect:

• Quantitative model application (Finnerty, Chaffe, Asian put)
• Consistent application of the selected model
• Consideration of expected time to liquidity
• Company-specific adjustment factors documented

The FairvalueX approach: We apply multiple DLOM models and show the calculation for each. The selected discount references specific model outputs and documents any company-specific adjustments with supporting rationale.

4. Backsolve and Calibration

What auditors examine: Does the valuation reconcile to recent transactions?

If the company has had a recent financing round, auditors will question any significant departure from the implied enterprise value. They look for:

• Backsolve analysis from recent preferred stock transactions
• Explanation of any differences between backsolve and primary analysis
• Consideration of whether financing terms included non-standard features

The FairvalueX approach: When applicable, we perform backsolve calibration and present a reconciliation showing how our independent analysis compares to implied transaction values. Any differences are explained with reference to specific factors.

5. Revenue and Financial Projections

What auditors examine: Are projections reasonable and consistently applied?

For income approach valuations, auditors will compare management projections to:

• Historical performance and trends
• Industry growth rates and benchmarks
• Previously provided projections (for consistency)

The FairvalueX approach: We document the source of projections, any adjustments made, and the basis for key assumptions. For PWERM, each scenario's probability weighting is explained with reference to management's view and market evidence.

The Safe Harbor Standard

Treasury Regulation Section 1.409A-1(b)(5)(iv) provides safe harbor protection for valuations that meet specific requirements:

Meeting safe harbor requirements shifts the burden of proof to the IRS, providing significant protection in the event of an examination.

Documentation That Survives Scrutiny

Every FairvalueX 409A valuation includes:

• Executive Summary with key conclusions and critical assumptions
• Methodology Selection Rationale explaining the approach chosen
• Detailed Calculation Exhibits showing all inputs and formulas
• Comparable Company Analysis with selection criteria and data sources
• DLOM Analysis using quantitative models with full calculations
• Sensitivity Analysis on key value drivers
• Safe Harbor Compliance Checklist confirming regulatory requirements