What section 409A actually requires of a startup

Why an option grant is a tax question at all

Section 409A of the Internal Revenue Code governs nonqualified deferred compensation. A stock option granted with an exercise price at or above the fair market value of the underlying stock on the grant date is outside its scope; one granted at a discount is not, and the consequences land on the person holding the option.

Where a plan fails, the statute requires the deferred compensation to be included in gross income and increases the tax by the sum of interest at the underpayment rate plus one percentage point and "an amount equal to 20 percent of the compensation which is required to be included in gross income" (26 U.S.C. 409A(a)(1)(B)). The final regulations implementing it were issued as T.D. 9321 and published in Internal Revenue Bulletin 2007-19 (IRS).

The general standard

For service recipient stock that is not readily tradable on an established securities market, fair market value "means a value determined by the reasonable application of a reasonable valuation method", judged on the facts and circumstances as of the valuation date. The regulation lists the factors: tangible and intangible assets, the present value of anticipated future cash flows, market values of comparable companies determined through nondiscretionary objective means, recent arm's length transactions in the stock, and other relevant factors such as control premiums or discounts for lack of marketability (Treas. Reg. 1.409A-1(b)(5)(iv)(B)(1)).

Two sentences in that paragraph do most of the practical work. A method is not reasonable if it does not consider all available information material to value. And using a previously calculated value is not reasonable if the calculation fails to reflect information available afterwards that may materially affect value, or if the value was calculated for a date more than 12 months before the date it is being used for.

The three presumptions

Independent appraisal

A valuation of a class of stock determined by an independent appraisal meeting the requirements of section 401(a)(28)(C) and the regulations, as of a date no more than 12 months before the relevant transaction. This is the route almost every venture-backed startup takes.

Formula price

A valuation based on a formula that would be treated as fair market value under the nonlapse restriction rules of section 83, applied consistently for every transfer of that class of stock, subject to conditions.

Illiquid start-up

A valuation made reasonably and in good faith, evidenced by a written report taking the listed factors into account, for illiquid stock of a start-up corporation: no material trade or business conducted for 10 years or more, no publicly traded equity, and no put or call obligations beyond a right of first refusal. It does not apply if a change in control is reasonably anticipated within 90 days or a public offering within 180 days.

Where a presumption applies, the IRS can only rebut it "upon a showing that either the valuation method or the application of such method was grossly unreasonable". That shift in the burden is the whole commercial value of buying a 409A valuation.

What the start-up presumption asks of the appraiser

A valuation is not treated as made reasonably and in good faith unless it is performed by a person the corporation reasonably determines is qualified, based on significant knowledge, experience, education or training. The regulation says significant experience generally means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending or comparable experience in the line of business or industry the company operates in.

Nothing here is tax or legal advice, and the summary above compresses a long regulation. Read the section itself, and take advice on your own facts before granting options.