Do you really need a 409A?

If you plan to issue stock options or other forms of equity as compensation, assuming you want to comply with tax law, the short answer is YES, you need a 409A fair market value report. Section 409A requires companies that issue stock options / equity to do so at no less than fair market value.

As young lawyers in Silicon Valley, we saw the boards of directors of many startups use rules of thumb based on the company’s preferred stock price to price the company’s options. Issuing options at 10%, 5% (or even 1%!) of the preferred price was quite common. This approach was simple and created cheap option prices to help companies attract, retain and incentivize employees.

 

The problem is that the process those boards utilized to determine the fair market value of the options granted to employees was not based in any real valuation methodology. We are reminded of the common refrain: “There are no rules of thumb in valuation.”


Those “rules of thumb” got people in trouble because they resulted in value determinations that were completely untethered from the real value or price per share of the options companies were granting. So, Congress stepped in and enacted Section 409A of the Internal Revenue Code, mandating strict requirements on nonqualified deferred compensation plans (which include most stock option plans).


If you hire the right firm, Section 409A fair market value reports are quick, generally inexpensive, and they keep the company in compliance with tax law, an extremely important issue if you hope to go public or sell the company in the future.

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Why you shouldn't do your 409A yourself

Prior to 2007 (thank you for nothing Enron!), stock option grants were not taxable events. Now that Section 409A is part of the Internal Revenue Code, to issue a stock option grant to an employee without triggering a tax event, you must demonstrate that the fair market value of the stock options is “reasonable.” If you can demonstrate reasonableness, your employees may be able to take advantage of what is called the 409A “safe harbor.”


The easiest way to get that safe harbor for your employees is to engage a qualified, independent valuation specialist to perform the 409A fair market value analysis. Caroline Moon at Andressen Horowitz has used a good analogy to explain the rationale underlying the independence of the specialist: when you seek a mortgage lender for your home, the mortgage lender uses an appraiser to determine the value of your home. The mortgage lender doesn’t want to know your your opinion of the value of your home because you’re biased – they want the value determined by someone who can give them a dispassionate, arm’s-length (independence is really important!) assessment.


But simply hiring an independent third party to do the Section 409A analysis alone is not enough. You and your board still have a legal duty to ensure that the valuation expert’s work is reasonable and defensible. Remember the work must be reasonable to gain the protection of the safe harbor. Moreover, defensibility is critical because financial statement auditors, the SEC (if you go public), the IRS and potential acquirors may challenge the analysis even if you worked with a independent third party valuation specialist.


One interesting side question that you should ask yourself: Is my Section 409A fair market value assessment provider independent if they or an affiliate of their's provides other services to the company, such as cap table management services?

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