Valuation Standards and Regulations in Venture Capital

· 11 min read
venture-capital finance

If you spend enough time around venture-backed companies and the funds that invest in them, you’ll hear people throw around terms like “409A valuation,” “ASC 820,” and “Rule 2a-5” as if they’re all part of the same thing. They’re related, sure, but they serve different purposes, apply to different parties, and operate under different assumptions. During my time as Head of Data Science at Aumni, I saw how much confusion these standards caused, even among people who dealt with them regularly. Let me try to untangle the three main valuation standards and regulations that govern how private companies and venture funds determine fair value.

This post is for informational and educational purposes only. Nothing here is legal, tax, or investment advice. Consult qualified professionals before making any decisions based on this content.

409A Valuations: Pricing Common Stock for Tax Purposes

A 409A valuation is what private companies use to determine the fair market value of their common stock, primarily for setting the exercise price of employee stock options. The name comes from Section 409A of the Internal Revenue Code, which establishes the rules around deferred compensation.

The practical purpose is straightforward: when a company grants stock options to employees, the IRS requires that the exercise price be at or above fair market value. If you set it too low, the options are treated as deferred compensation, creating a tax headache for the employees receiving them (including a 20% penalty tax). Nobody wants that.

Key characteristics of 409A valuations:

  • What they value: Common stock of a private company
  • Who needs them: Any private company granting equity compensation to employees
  • How often: At least annually, or whenever there’s a material event (like a new funding round)
  • Methodology: Typically uses a blend of market, income, and asset-based approaches, with an emphasis on conservatism
  • The output: A fair market value per share that serves as the floor for option exercise prices

The conservatism point is worth emphasizing. 409A valuations tend to produce lower values than you might intuitively expect. The valuation applies to common stock, which sits below preferred stock in the liquidation waterfall, and the methodology accounts for the lack of marketability and minority discount that common shares carry. A 409A valuation for a company that just raised at a $100M pre-money valuation might peg common stock at a fraction of the preferred price per share. That’s not a mistake. It reflects the genuine economic differences between common and preferred equity.

ASC 820: Fair Value for Financial Reporting

ASC 820 (also called the Fair Value Measurement standard) is a different animal entirely. It’s part of Generally Accepted Accounting Principles (GAAP) and provides a framework for measuring fair value in financial reporting. Where 409A is about pricing common stock for tax compliance, ASC 820 is about accurately measuring the fair value of assets and liabilities for financial statements.

For venture capital funds, ASC 820 is the standard they apply when valuing their portfolio holdings, which are typically preferred equity. This is a key difference from 409A: funds are valuing preferred shares, not common stock, and preferred shares have materially different economic characteristics (liquidation preferences, anti-dilution protections, and so on).

Key characteristics of ASC 820:

  • What it values: Assets and liabilities at fair value (for VC funds, this means portfolio company holdings)
  • Who needs it: Investment funds and other entities that report under GAAP
  • How often: Typically quarterly or annually, depending on reporting requirements
  • Methodology: Uses a hierarchy of inputs categorized into three levels. Level 1 inputs are observable market prices (not really applicable to private companies). Level 2 inputs are indirectly observable market data. Level 3 inputs require significant judgment, which is where most VC portfolio valuations land
  • The output: A fair value measurement reflecting the price that would be received to sell an asset in an orderly transaction between market participants

The Level 3 categorization deserves attention since that’s where almost all VC portfolio valuations end up. Level 3 means the inputs are unobservable, relying on the fund’s own assumptions about what market participants would use in pricing the asset. This gives funds significant latitude in how they arrive at fair value, which is both a feature and a potential problem. It’s a feature because private companies genuinely don’t have observable market prices. It’s a potential problem because that latitude can be exercised in self-serving ways, which is exactly why regulators have tightened the rules around how funds govern their valuation processes.

The 409A vs. ASC 820 Disconnect

For the same company at the same point in time, the 409A valuation of common stock and the ASC 820 fair value of preferred stock can be very different numbers – and both can be “correct” within their respective frameworks. A founder might see their 409A valuation come in at $5 per share while their lead investor’s fund is carrying the preferred at $20 per share. Both numbers are legitimate, but they’re answering different questions about different securities using different methodologies.

The distinction matters depending on who you are:

  • Startups issuing equity compensation need 409A to price options correctly and avoid tax penalties.
  • Venture funds reporting to LPs use ASC 820 to govern how portfolio value is reported, which flows into performance reporting, fee calculations, and regulatory compliance.
  • Anyone trying to understand what a company is “worth” needs to know which standard produced the number and what assumptions went into it.

While the methodologies share a lot of DNA (both can use market, income, and asset-based approaches), they’re optimized for different objectives. 409A valuations lean conservative because the tax code penalizes overpricing. ASC 820 valuations aim for accuracy because GAAP requires faithful representation of financial position.

This creates a genuine tension when a VC fund uses a company’s 409A as an input to their own ASC 820 analysis. A 409A might be a reasonable data point, but it shouldn’t be the sole basis for a fund’s fair value determination. The most sophisticated funds and their auditors understand this distinction well. They’ll use 409A valuations as one data point among many, layered with comparable transactions, recent funding round pricing, and their own modeling of the preferred stock’s specific economic terms. I’ve seen cases where a fund’s auditor pushed back on a valuation because the fund was essentially just referencing the 409A and calling it a day. That’s not sufficient under ASC 820, and it becomes even more problematic under the governance requirements that Rule 2a-5 introduced.

SEC Rule 2a-5: The Regulatory Layer

Registered investment companies (mutual funds, closed-end funds, and business development companies regulated under the Investment Company Act of 1940) are required to comply with SEC Rule 2a-5, officially titled “Good Faith Determination of Fair Value.” Most venture capital funds are private funds that rely on exemptions from the Investment Company Act, so Rule 2a-5 doesn’t directly apply to them. But the rule is worth understanding because it’s increasingly influencing how the broader industry thinks about valuation practices, and LPs often expect similar governance standards regardless of registration status.

The short version: Rule 2a-5 formalized a lot of things that were previously considered best practices. What used to be “you should probably do this” became “you are required to do this, and here’s exactly what the SEC expects.”

Before Rule 2a-5, fund boards had a general obligation to determine fair value in good faith. The rule made that obligation specific by laying out four concrete requirements.

Assess and Manage Valuation Risks

Funds must actively identify and assess potential risks that could affect fair value determinations. This includes conflicts of interest (the people managing the portfolio have incentives around how those assets are valued) and external factors like market dislocations that could distort pricing. This is an ongoing obligation, not a one-time exercise.

Apply Fair Valuation Methodologies Consistently

The SEC requires documented valuation methodologies applied consistently across a fund’s portfolio. This means specifying the key inputs and assumptions used for each holding, applying those methods in a transparent and repeatable way, and periodically reviewing methodologies for appropriateness. The goal is to prevent a situation where a fund uses one methodology for holdings that performed well and a different one for holdings that didn’t.

Test Regularly

Fund boards (or their designees) are required to regularly test their valuation approaches to make sure they remain suitable as market conditions change. The SEC deliberately didn’t specify a minimum testing frequency, which gives funds some flexibility. But the expectation is clear: valuation methods need ongoing validation, not a set-it-and-forget-it approach.

Oversee Third-Party Pricing Services

If you use third-party pricing services, the board is responsible for approving, monitoring, and evaluating those providers. You can’t outsource your valuations and wash your hands of the methodology. This reflects a common pattern where firms would hire a third-party valuation firm, accept whatever number came back, and treat it as settled. The SEC wants boards to understand how those numbers were generated and whether the third-party’s methods are appropriate for the fund’s specific holdings.

The Valuation Designee: A Structural Shift

One of the more interesting structural changes in Rule 2a-5 is that it allows the board to assign fair value determination responsibilities to a “valuation designee,” typically the fund’s investment adviser. This makes practical sense because the investment team usually has the deepest knowledge of the portfolio companies.

But there’s a catch. The rule specifically says that the valuation designee should “reasonably segregate” the fair value determination process from the portfolio management function. The SEC recognizes the inherent conflict: the same people making investment decisions shouldn’t be the only ones determining what those investments are worth. Whether that means an independent valuation committee, third-party valuation providers, or some other structural separation, the point is to reduce the risk that valuations are being influenced by portfolio managers’ view of how things should look rather than how things actually are.

How These Standards Work Together in Practice

Understanding each standard individually is useful, but the real picture only comes into focus when you see how they interact. A venture fund operating today is likely dealing with all three simultaneously.

Imagine a Series B company in your portfolio. The company itself will commission a 409A valuation to price its employee stock options, which might value common stock at $8 per share even though the last preferred round priced at $25 per share. Meanwhile, your fund needs to report the fair value of its preferred holdings under ASC 820 for quarterly financials. And if you’re a registered investment company, Rule 2a-5 dictates how you govern and document the entire process of arriving at that ASC 820 number. Even for private venture funds that aren’t directly covered, the governance framework has become an industry benchmark.

Think of it this way: ASC 820 tells you what question to answer (what is fair value?), 409A provides one specific answer for one specific security (common stock for tax purposes), and Rule 2a-5 tells you how to govern and document the process of answering the ASC 820 question for your fund.

For funds that fall under Rule 2a-5 (or that adopt its framework voluntarily, as many institutional-quality funds now do), this means maintaining a formal valuation policy with documented methodologies, regular board oversight of valuation results, a testing framework for validating your approaches, and clear documentation of how the valuation function is separated from portfolio management.

The Broader Trend Toward Transparency

While Rule 2a-5 technically only applies to registered investment companies, its influence extends further. Private venture funds, whether managed by RIAs or ERAs, are increasingly adopting similar practices, partly because LPs are asking for it and partly because it represents sound governance. If your LPs include institutional investors, they’re going to expect valuation practices that are at least in the neighborhood of what Rule 2a-5 requires, regardless of your registration status.

This is one of those areas where getting ahead of the requirements, rather than scrambling to comply at the last minute, pays real dividends in terms of LP confidence and operational smoothness during audit season.

What to Actually Remember

Always ask which standard produced the valuation number you’re looking at. A 409A number, an ASC 820 number, and a “valuation” someone mentions casually at a board meeting might all be referring to different things. Understanding the framework behind the number is just as important as the number itself.

For founders, keep your 409A current before granting options. Stale 409As are one of the most common compliance issues, especially at fast-growing companies that have material events between annual valuation updates. For fund managers, make sure your ASC 820 process is well-documented, consistent, and aligned with Rule 2a-5 governance standards (which apply directly if you’re a registered investment company, and are increasingly expected by LPs regardless). For everyone else in the ecosystem, knowing that these different standards exist and serve different purposes puts you ahead of most people in the room.

The venture ecosystem has a tendency to treat “valuation” as a single concept when it’s really a family of related but distinct measurements. Getting comfortable with that complexity doesn’t require a finance degree. It just requires asking the right questions about which standard, which security, and which assumptions are behind any number someone puts in front of you.

Further Reading

Some of the data and analysis in this post originally appeared on the Aumni blog and here.