Assume your company recently had a significant positive development —a recent financing, a product launch, significant revenue growth, or perhaps even the possibility of an acquisition (or hypothetically, an IPO). Those are all good things obviously, but afterward the company needs to consider how its value has changed, and what impact that has on equity plan, especially for tax purposes. Tax laws generally, and Section 409A especially, require that exercise prices (or “strike prices”) of options issued to employees be set at or above the fair market value of the underlying stock to avoid penalties.
What is 409A?
IRC Section 409A regulates “nonqualified deferred compensation” plans, including among other things, stock options. 409A requires that stock options or grants be issued at or above the fair market value (“FMV”) of the underlying stock of the company (almost invariably the common stock). This is meant to ensure that stock options that are issued already “in the money” (where the strike price is less than the FMV), are treated as compensation and taxed at the recipient’s ordinary income tax rate (with the company doing proper withholding to boot). Penalties for non-compliant options apply both to the company (stiff penalties on the company for failing to withhold) and the employee (a 20% excise tax, in addition to the underlying tax, plus interest).
There is a common misunderstanding that incentive stock options (“ISOs”) are not subject to 409A, which is sort of true but mostly not – ISOs are required to be issued at FMV to qualify as ISOs in the first place, so to the extent an ISO is issued with a strike price below FMV and thus fails to qualify as an ISO, it is a non-qualified stock option and is thus subject to 409A.
What do Startups do to address 409A?
The company needs to determine the FMV of its common stock, which for 409A purposes is a “value determined by the reasonable application of a reasonable valuation method” based on all the facts and circumstances. The rules provide a number of “safe harbor” ways to determine FMV:
- Independent Appraisal. A valuation done by a qualified independent appraiser annually. Established start-ups are more likely to use this method, especially after institutional investors fund the company. Costs for valuations vary depending on the company’s stage of development; for very simple companies, there are somewhat dubious DIY services for a few hundred dollars, as well as more reputable services (some of which update periodically rather than annually) in the $2-3,000 per year range.
- The true “start-up” safe harbor - A good faith written valuation of a private (“illiquid”) company (conducted no material business for more than 10 years (including any predecessor company) (i.e., most startups)) prepared by someone (including internal people) who has at least 5 years of relevant valuation or similar financial experience in the same line of business as the company. This safe harbor doesn’t apply if there is a reasonable expectation that the company will be sold (or have an IPO) within 90 days.
- Formula-based Valuation. A complicated valuation approach that applies if the option is subject to a permanent company purchase right at a formula price. Also requires that the company use the same valuation formula for all valuations of company stock. Most startups do not use this safe harbor
Generally, valuations are good for 12 months, or until some event occurs that could materially affect the value of the company, whichever happens first.
Why are these safe harbors important? Because when a company’s valuation method falls under a safe harbor, the IRS—not the company—has the burden of proving that the valuation was too low.
How do I pick the best approach for my company?
For a brand new startup with no operations or financings behind it, history suggests that the IRS is unlikely to bring a 409A claim (having not done so in the 11+ years of 409A’s existence). Most true startups without money for an independent valuation probably do their best reasonable determination of FMV, even if it doesn’t fit precisely into a safe harbor.
A company that has had a material change in value, and especially a company with professional investors, will usually get an independent valuation, especially given the relatively low cost involved now. Valuations were a lot more expensive when 409A was still fairly new.
To an extent, choosing an approach is a lot like choosing insurance, because different approaches may or may not legally shift the IRS’ burden of proving the options are non-compliant. But the least-risky option (independent valuation) is also the most costly.
On top of the audit and tax risk, failure to obtain an independent valuation may complicate a company’s potential exit. Undervaluing options carries such great penalties that a potential purchaser, during its due diligence process, will look to see whether a company properly valued its stock.