Staying Compliant with the Tax Code when Issuing Equity Grants Requires Proper Planning
Early-stage companies typically use stock options to compensate and incentivize service providers, like employees, consultants, directors, and advisors. Stock options are the right to purchase a certain number of shares of the company’s stock at a fixed price, known as the exercise price or strike price. Equity compensation is a valuable tool for companies looking to attract and retain ownership-minded service providers that are motivated to align their performance with the company’s goals. As service providers work, they add value to the company, and in return, the value of the company rises, as does the value of the provider’s equity in the company.
Importantly, options granted to service providers must comply with a complex set of tax and securities regulations. In this blog, we discuss 409A valuations and explain why they are important for early-stage companies.
What is a 409A valuation anyway?
A 409A valuation is a legally required evaluation of the fair market value of a company’s common stock, typically performed by an independent third-party appraiser. The valuation is used to determine the exercise price of stock options and other equity-based compensation provided to the people providing services to the company.
The purpose of the valuation is to comply with Section 409A of the Internal Revenue Code, which governs the taxation of non-qualified deferred compensation. Under 409A, if the exercise price of a stock option is less than the fair market value of the stock on the grant date, the difference between the exercise price and the fair market value is considered taxable income to the employee at the time of exercise. When a 409A valuation is conducted by an independent party, it establishes a safe harbor, meaning the exercise price is generally presumed to be “reasonable” by the IRS.
Under Section 409A, if a company issues stock options at less than fair market value, there can be significant penalties for both the company and the individual receiving the options. These penalties include additional taxes and interest on the difference between the fair market value and the exercise price of the options, as well as potential penalties for the company. Additionally, a failure to comply with Section 409A may raise significant due diligence issues during a financing or exit transaction.
To avoid this outcome and ensure compliance with federal regulations, companies must ensure that the exercise price of stock options is at least equal to the fair market value of the stock at the time the option is granted. A 409A valuation provides the necessary documentation for this purpose. Once received, the board of directors of the company must approve the valuation before issuing stock options at a price equal to fair market value or greater.
In summary, a 409A valuation is a formal evaluation of the fair market value of a company’s common stock, typically performed by an independent third-party appraiser. It is a crucial tool for early-stage companies to ensure compliance with tax laws and to avoid unintended tax consequences for the company and service providers who receive equity-based compensation.
