Running a startup means that at the same time you are busy building your product, your team, and your business, you also have to build your knowledge of arcane topics, like Section 409A of the Internal Revenue Code (IRC 409A) and its implications.

What is IRC 409A and why do I care?

IRC 409A says, in short, that stock options must be issued with an exercise price at least equal to the fair market value (FMV) of one share of the company’s common stock. (409A applies to stock options not restricted stock, and if the grantee owns 10% or more of the company, like a founder who receives option grants over and above his or her founder shares, the stock must be issued at 110% of fair market value.)

If you’ve adopted a Stock Incentive Plan or are getting ready to, your attorney has likely told you that option grants issued under that Plan must be approved by your board of directors and that your board must also establish the fair market value of the underlying common shares in order to set the exercise price.

Establishing Fair Market Value

If you are ready to grant equity to your employees, board members, advisors, and/or consultants, how are you supposed to determine the fair market value of a share of your company? Compliance with IRC 409A means that the board must employ a “reasonable valuation method” to establish FMV. Traditionally, companies have gone down one of two paths to meet the requirements of IRC 409A:

• 409A Valuation Report – The company pays for an external valuation expert to prepare and sign a detailed 409A Valuation Report, and the board approves a resolution to adopt the FMV established in the report, OR
• Analysis – The board approves a resolution (typically drafted by the company’s lawyer) that lists all the factors the board considered in establishing FMV and then another resolution to set the per share price.

Your board must establish the FMV of the underlying common shares to set the exercise price each time option grants are issued under your Stock Incentive Plan. A 409A Valuation Report is good for 12 months unless there has been a material change in the business (e.g. new financing).

The Valuation

Common approaches for determining FMV include consideration of company assets, company income, and comparable companies. You should expect to have your capitalization table, term sheets, articles of incorporation, financial projections, and any past 409A reports readily available as inputs into the valuation process.

The Sliding Scale of Tax Risk

If the IRS challenges a valuation, the methodology relied upon by the company’s board to derive that FMV will help determine how solid your footing is.

A 409A Valuation Report prepared by an outside expert is considered rock-solid for the most part and actually provides a so-called “safe harbor,” meaning that the IRS must demonstrate that the valuation is “grossly unreasonable” in order to invalidate it.

However, valuation providers vary in experience and thoroughness. Beware of chop shop 409A vendors who provide reports based on your cap table and little additional information—tell-tale signs of a poor report, the substance of which (or lack thereof) may not qualify you for the 409A “safe harbor.”

Methods for establishing FMV without a 409A Valuation Report span the risk spectrum. A board resolution that just regurgitates IRS tax code without pointing to any analysis is arguably not compliant. However, if the valuation is based on a detailed Excel-based analysis vetted by industry experts, your tax risk can change dramatically.

Repercussions of 409A Noncompliance

If the IRS were to challenge an equity grant’s compliance with IRC 409A (i.e. an option was issued with an exercise price below FMV), they often take the position that the grant recipient owes tax on the difference between the exercise price and what they think (in hindsight) FMV was at the time of the grant. The rub? If the IRS actually challenges this, it’s almost certainly going to be after a liquidity event (e.g. the sale of the company or the company’s IPO). So, in the intervening years, interest on that tax obligation accrues and the IRS applies a tax penalty (usually 20%) to add salt to the tax wound. The federal and any applicable state tax rates can be painfully high. This tax burden will land on the grant recipient who is typically an employee or ex-employee, but the company may have some additional exposure because granting equity below FMV may have required a withholding obligation. Let’s not even talk about how an acquirer of your company may react to lingering tax risk associated with non-compliance. Needless to say, the IRS heavily incentivizes compliance.

Fidelity Can Meet Your 409A Needs

Fidelity partners with highly qualified and independent 409A valuation providers with offerings that are 409A compliant and competitively priced. Learn more.

Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation. Third party mentioned and Fidelity are not affiliated.