Some startups that fail to handle founder stock issuances correctly try to fix the problem later, often when the company is significantly more valuable. However, you cannot simply issue stock or stock options at par value when the company’s actual fair market value (FMV) has already increased. This can lead to major tax liabilities and penalties if not handled properly.
Imagine a startup issues valuable founder stock (subject to vesting) for just $100, and the founder timely files a Section 83(b) election. The IRS or a future law firm or accounting firm performing diligence later determine the FMV of the stock was significantly higher - $5M. This discrepancy creates significant tax liabilities for the company and for the grantee. Here’s a high-level summary of the potential implications, using assumed/hypothetical tax rates for ease of math:
One of the ways to avoid this disaster is to do 409A valuation.
A 409A valuation is an independent assessment of the fair market value (FMV) of a private company’s common stock. It is named after Section 409A of the Internal Revenue Code, which governs the tax treatment of deferred compensation arrangements, and in some cases, imposes very punitive excise taxes. At a high level, deferred compensation under 409A refers to any arrangement where compensation is earned in one taxable year but paid in a later year. If deferred compensation is not compliant with, or exempt from, Section 409A, there can be hugely punitive taxes imposed, including on stock options structured incorrectly. Restricted Stock is generally never subject to Section 409A, however, stock issuances can still create tax risks if the IRS deems the FMV of the stock to be undervalued.
When issuing restricted stock or stock options, many founders wonder whether they need a 409A valuation. Legally, a 409A valuation isn’t required to issue stock or options. However, a 409A valuation is valuable because it is an independent third party’s assessment of the fair market value (FMV) of your company’s shares, providing a defensible valuation for tax and compliance purposes. When your company effectively relies upon a 409A valuation when issuing stock options, it creates a rebuttable presumption that the 409A valuation price is the correct exercise price for 409A purposes. In other words, the IRS has the burden of proof to demonstrate that the 409A valuation was incorrect, which is powerful protection and generally is enough to satisfy all future investors or acquirers that review your grants.
Obtaining and effectively utilizing a 409A valuation ensures that stock options and stock issuances are granted at an appropriate price, minimizing legal and tax risks. While a 409A valuation is not legally required to issue stock or stock options, failing to have one can expose companies and service providers to significant risks. For example, if the IRS determines that stock options were granted below FMV, the consequences can include:
For stock issuances, the risks are primarily related to missed withholding taxes, which, while still important, are generally less severe than the risks associated with stock options due to the incredibly punitive tax regime the IRS applies to discounted stock options.
There are rare instances where issuing options without a 409A might work, but they are limited in scope and risky. For example, if the company is at a very early stage with no revenue, no external funding, and minimal progress on its product or IP, some founders may choose to skip a 409A for small restricted stock grants. However, the consequences of being wrong are significant, and we strongly advise that you consult with sophisticated tax and corporate counsel before doing so.
To help evaluate your risk tolerance, here are some selected common factors that suggest the company’s value has risen:
While you’re not legally required to obtain a 409A valuation to issue stock or stock options, it’s a critical tool for managing risk, especially as your company grows. For stock options, a 409A is essential to avoid draconian penalties, and if you do issue stock options without a 409A valuation, investors will question it every time you raise money or go to sell. For stock issuances, it’s about balancing risk and demonstrating good faith in pricing. Always consider your company’s stage, progress, and funding when evaluating whether to proceed without a 409A.
If you’re unsure, consult with a trusted legal or financial advisor to assess your situation and determine the best path forward. The cost of a 409A valuation is small compared to the potential financial and reputational risks of skipping one.
Disclaimer
We caution that the above is a summary and general in nature (it does not, for example, address partnership equity incentives or non-US tax implications) and does not address specific circumstances that may be important to you individually. It is not individualized tax or legal advice. Always work closely with a skilled startup lawyer to navigate these complex situations effectively and to ensure compliance with tax laws while minimizing liabilities.
Thank you
We appreciate Brett Good, who co-authored this blog post.
