Startups rely on granting stock options to service providers, like employees and advisors. It’s the primary way to entice top talent to leave cushy corporate jobs for a chance at a life-changing startup exit.
A stock option gives the holder an option to buy shares at a certain price (known as the “exercise price” or “strike price”). The lower the strike price, the more attractive the option. But there are rules for setting the strike price. The most important one comes from a provision of the tax code known as Section 409A.
Thanks at least in part to the Enron scandal in the early 2000s, Congress created Section 409A of the Internal Revenue Code. Section 409A was designed to regulate taxation of deferred compensation, i.e., compensation which is or may be paid in a year following the year in which the legal right to the payment arises. This includes stock options and other forms of equity startups often grant to employees.
While Section 409A can come up in a number of settings, the most common place where startups will have to deal with it is in granting stock options. The goal for startups is typically to structure stock options so that they’re exempt from the requirements of Section 409A for nonqualified deferred compensation.
Related Post: Startups and Stock Options: ISOs vs. NSOs
Why is it Important for Startups to Get 409A Valuations?
For startups, the best way to structure stock options to be exempt from Section 409A in most cases is to obtain what’s known as a 409A valuation. A 409A valuation determines the value of the startup’s common stock on a per share basis. This value can then be used to set the exercise price of a stock option.
Example: Acme Inc. obtains a 409A valuation which determines that the value of the company’s common stock is $1 per share. Acme promptly grants a stock option to Jane Johnson to purchase 50,000 shares of common stock with an exercise price of $1 per share.
But why is a 409A valuation necessary? A 409A valuation is one of three “safe harbor” methods for valuing the fair market value (FMV) of a startup’s common stock. It’s considered a safe harbor because a 409A valuation creates a rebuttable presumption that such valuation represents the FMV of the startup’s common stock. That means the IRS would have the burden of proving the valuation didn’t represent the FMV, instead of the startup having the burden of proving the valuation did represent the FMV. This is a significant advantage for the startup. So significant, in fact, that at least for funded startups, the industry expectation is that all option grants and other forms of deferred compensation will be supported by a valid 409A valuation.
Tip: For startups that have raised outside financing or have significant assets, a 409A valuation should support any option grants. For early stage startups without funding or significant assets, they should assess risks with their legal team to determine whether a 409A valuation is necessary and whether alternative approaches may be viable.
The requirements for a 409A valuation to be valid are straightforward. A 409A valuation must be conducted by a qualified independent appraiser and on a date no more than 12 months before the date of the option grant. In addition, if there is an intervening “material event” (e.g., a startup raises money), then the startup will need to obtain a fresh 409A valuation before it can grant stock options, even if the prior 409A valuation was done within the prior 12 months. This makes sense: if the startup has raised money, then its value has likely increased, necessitating a reevaluation of the value of its common stock.
Example: Acme Inc. gets a 409A valuation on January 1, 2024, valuing the common stock at $0.50 per share. On September 1, 2024, Acme raises $5 million in a seed financing. Following the seed financing, Acme hires 10 new employees and promises them stock option grants. Despite having obtained a 409A valuation less than 12 months prior, Acme will have to obtain a fresh 409A valuation before granting these options because the seed financing was a material event requiring a new 409A valuation.
What Are the Risks of Not Getting a 409A Valuation?
If a stock option is granted at less than FMV, it’s subject to Section 409A. And that’s a problem because most stock option grants will fail to comply with Section 409A. That’s because while most stock options are structured to give the option holder flexibility on when to exercise the option and purchase shares, Section 409A strictly limits this kind of flexibility.
So what happens if a stock option fails to comply with Section 409A? In short, the startup service providers get punished. Below is a sampling of tax consequences to the option holder:
An additional 20% federal penalty tax is imposed on any deferred compensation that’s taxable under Section 409A.
Income tax is accelerated so that it’s recognized in the year of vesting instead of on the date the option is exercised.
Possible late penalties and interest on the taxable amount
Possible late penalties and interest on failure to withhold taxes
Realistically, startups that cause 409A violations should make efforts to make the impacted optionees whole, i.e., pay for the penalties. But there’s no guarantee that startups will always be in a financial position to do this and, in any event, it’s a bad look for the startup to cause 409A violation and can hurt morale on the team.
Tip: Even if service providers are never hit with these consequences, potential investors and acquirers will not be happy to see option grants unsupported by 409A valuations when doing due diligence. In their eyes, this makes the startup look incompetent and increases the riskiness of the opportunity.
Selling Restricted Stock as a Way to Avoid Section 409A
For early stage startups, particularly if they’ve not raised money, it may be viable to sell shares of restricted stock directly to service providers, rather than granting stock options. Early stage startups may not yet want to pay to obtain a 409A valuation and so may instead sell shares directly. Restricted shares are not deferred compensation and thus are not subject to Section 409A.
Example: TechTone Inc. incorporated 3 months ago and has no significant assets or outside investment. The founders want to bring on an advisor and grant a small percentage of equity. After speaking with their attorney, they decide to sell shares of common stock directly to the advisor at $0.0002 per share, rather than obtaining a 409A valuation and granting the advisor a stock option.
There can be other tax risks with selling restricted stock, and so it should not be pursued blindly, but it can be a viable alternative to granting stock options for certain early stage startups.
When Should a Startup Get a 409A Valuation?
A startup should usually get a 409A valuation at the following times:
Before it issues stock options for the first time
After raising outside financing or the occurrence of any other “material event”
At least once every 12 months
How Does a Startup Get a 409A Valuation?
The most common way startups get 409A valuations is through cap table management companies like Carta, Pulley, and others, which bundle 409A valuations within other products offered as part of a subscription tier. However, there are plenty of other valuation firms that startups may work with directly to get a valuation.
Startups should be prepared with information to provide to the valuation provider, including things like:
Basic company details
Does a Low 409A Valuation Mean a Low Valuation From Investors?
First time founders are often concerned that a low 409A valuation will mean that VCs will assign the same value to the company. While this concern is understandable, it's unfounded.
A 409A valuation estimates the fair market value (FMV) of a company's common stock, often factoring in discounts due to minority interests and limited marketability. In contrast, a venture capital valuation arises from discussions between investors and company founders, determining the cost per share for a fresh set of preferred stock during fundraising. This preferred stock usually carries added privileges, like a liquidation preference, making it more valuable than common stock.
Given the different contexts and stock classes these two valuations address, it's very uncommon for a 409A valuation to influence the valuation investors will assign to a startup in a financing.
409A valuations may seem like unnecessary red tape to deal with for startups, especially at an early stage. While there may be ways to avoid them for a time, it’s only a matter of time before startups will need to embrace the role of the 409A valuation as good governance and protection for their team.