409A is basically a regulatory tool that was enacted to prevent underpricing of so-called deferred compensation. It can impose drastic penalties and so every founder, from the start, ought to know what it is and where it can bite you.
What 409A says basically is that if you underprice any form of “deferred compensation”, then the recipients of that compensation must pay some serious penalties. The flavor of it can be imagined by thinking of the Enron and WorldCom execs who vamoosed with large bags of gold even as small investors lost their life savings when their companies came crashing down at the turn of the century – the idea being that rules should be in place to prevent de facto lootings of companies via executives who grant themselves valuable compensation packages at far below market rates as a way of enriching themselves at the expense of a company and its shareholders.
The issues surrounding 409A are complex but in the startup world it basically affects stock option pricing: if you underprice stock options, the recipients can suffer dearly from this mistake.
Well, in the startup world, there are two types of tax penalties that can apply if you try to transfer value to key people at something less than fair market value.
The first (discussed extensively in Q&A 6) is what might be called the “83(a) penalty.” The second (discussed below) is the 409A penalty and it is potentially far worse.
What is the 83(a) penalty? Well, if you make a stock grant to a founder or other key person at less than its fair value, that person has to pay tax based on ordinary income tax rates on the difference. Say you are rolling as a company and have generated some good sales and a lot of interest, enough to attract the interest of a potentially valuable new person who is so good you may want to add that person as a late founder. Say a board wants to grant that person 5% of the company, or 500K shares on a 10M share model.
And say you want to use founder pricing, such as $0.001/sh. It does the stock grant and, on its face, the shares granted are worth $500 based on the stated pricing and the new founder pays $500 for them and then has to earn them out through vesting. In doing so, the board has determined that the company in total is worth $10K, with 5% representing a $500 piece of it. Since this is not at the very beginning, let us also say that the company already is doing hundreds of thousands in sales and is growing rapidly at the time this grant is made. It is still an ill-defined time in terms of valuation given that the company is still pre-funding and so the board takes its chances in doing one last “cheap” grant to this new founder.
But then, a couple of years later, the company is audited and the tax authorities determine that it was worth not $10,000 but $1M. In that case, the 5% piece was worth not $500 but $50K. The recipient thus paid $500 for $50K worth of stock and, as a service provider earning that stock, effectively received $49,500 in additional compensation.
This is the 83(a) penalty. If stock is undervalued and granted to someone at the undervalued price, that person may wind up having to pay ordinary income tax to the extent of the amount of the undervaluation.
All very well and good, but pretty straightforward. You are employed. You work for compensation. Your boss tries to say it is compensating you with x, you report and pay tax on x, but in fact your boss gave you 10x. You get caught and you have to report the 9x part and pay tax on it because this was previously underreported compensation. You pay tax once on the difference.
Now consider the 409A penalty. This applies to undervaluing deferred compensation or, in the startup context, stock options. Say you grant 100K options to some key employees with an exercise price of $.10/sh. In fact, you are undervaluing the options, which should objectively be valued at $.50/sh. The amount of the undervaluation does not really matter.
The key is that the options are undervalued. Now, if we assume a penalty should apply to this, we might think of it in terms of the 83(a) penalty. An employee got 100K options exercisable at $.10/sh when they should have been exercisable at $.50/sh. So the employee exercises and pays $10K for the 100K shares when the employee should have paid $50K instead if the options had been properly valued. You get caught on audit. What is the penalty? Well, common sense (and an 83(a)-type measure) might suggest that you have to pay tax on the $40K difference and that is your penalty for having undervalued the options.
But that is *not* how 409A works. Under 409A, you do not get penalized just for what happened on the date of grant but more for what happens on your big payday. Technically, the penalties apply at each vesting point but let us dramatize and simplify this to show just how draconian 409A penalties are. Let us say that the key employee who got the $.10/sh options that were in fact worth $.50/sh on date of grant has a big payday (say, exit on M&A) at which time the shares are worth $5.00/sh.
If that were also the big vesting point, then here is what would happen under 409A: the employee gets $500K from the acquisition proceeds; the employee would then have to pay, as a 409A penalty, a penalty of 20% of the difference between $500K and $10,000 (i.e., $98K); in places like California, the employee would also have to pay a penalty under state law of another 20% on that same spread (i.e., another $98K); finally, the employee would have to pay *ordinary income tax* on the difference between $500K and $10K (or another $167K if you assume a 34% tax rate).
So, as a total penalty for underreporting $40K worth of “deferred compensation,” the employee loses capital gains treatment on his $490K gain on exit (by which he might have paid a total tax of just over $100K) and instead pays 409A penalties amounting to some $365K on a $490K gain. That is, about 75% of his big payday reward goes to the taxman as 409A penalties.
Now *that* is punitive.
What does all this mean in practical terms for founders?
Well, in the earliest stages (normally before first equity funding), it means you can usually ignore 409A when doing your equity grants.
Why? First, 409A applies to option grants but *not* to restricted stock grants. If you are over-aggressive in doing restricted stock grants, and these are later audited, they are subject to 83(a)-style penalties, i.e., a one-time tax on the spread as it existed on the date of grant. Since stock options are not normally used with founders, 409A simply does not apply to the types of grants typically made.
Second, valuation is so nebulous at this early stage that it is virtually impossible for the tax authorities to second guess the valuations used by a board of directors. What confirms the relative safety of proceeding at this stage without taking steps to comply with 409A? Because top lawyers, accountants, and executives in countless deals involving major fundings and M&A do not care if 409A compliance were taken in these sorts of pre-funding situations. It is, in effect, a safe zone from 409A (though 409A does technically apply even at this stage).
What changes this and brings things to a point where you need to concern yourself much more carefully about 409A? One of two things: either a first equity funding (a “priced round”) or a situation in which some objective measure of valuation exists by which an outside person can come in and make a reasonable valuation of the company (usually this means you have some big contracts or existing revenues such as to make it absurd to continue to say that your whole venture is worth only a few thousand dollars). If either of these things is in place, and you are going to be granting stock options, then it is critical to comply with 409A before doing the option grants.
What does it mean to take steps to comply with 409A?
Well, 409A penalizes undervaluation. If you are on a strict budget, like to walk on a high wire without a net, and don’t expect that you will face any serious risk of audit, you can try to do a fair valuation as a board and take your chances when you price and grant options. Remember, it is the employee who will be at risk and employees get pretty upset to watch their payday reward evaporate before them. Therefore, prudent practice really requires that companies do not try to simply guess at what a proper valuation might be. If, however, you have done option grants without bringing them within the safe harbor (see below), you’re not totally defenseless if you are audited. You can still try to prove that the valuation was proper. The problem, of course, is that, if you lose, potentially serious penalties apply.
That said, the prudent way of complying with 409A is to have your company avail itself of 409A’s safe-harbor provisions. Basically, if you get an outside independent valuation to set the value of your options (naturally called a “409A valuation”), you normally can rely on this valuation in setting your option pricing. It is a “safe harbor.”
A 409A valuation carries with it a “presumption of validity” for one year. This means that, when the year is up, you either need to do a follow-on valuation to extend it for another year or you need to stop granting options. If you have a gap, that is fine as long as options are not issued in the interval. Once a new valuation is in place, you can resume doing grants.
If you do mess up and issue options that are at risk under 409A, you should be diligent to take corrective steps and not just let the issue lie. No one may squawk at the time but the issue will come up in due diligence at your next funding or during any M&A deal or IPO. And what do you do then, when you have a VC or an acquirer saying that you need to set aside a bunch of option grants that your key people have been relying on? So, if you have defective grants, move proactively on the issue to clean them up.
The tax law basically gives you one year within which you can do a “redo” of a grant to avoid the 409A penalties. Even then, there will be pain associated with the correction because any corrective grants will need to be priced at the proper fair market value, which by definition will be higher than the price of the superseded grants. And, if this means your key people who thought they could exercise their options at, say, $.25/sh suddenly are told they will need to pay, say, $1.00/sh, then you have some problems to deal with. All of this is normally fixable but not without cost. But leaving the problems so that they cannot be fixed without incurring the 409A penalties is far worse. So take steps to address them quickly.
It cannot be emphasized strongly enough how important this sort of technical compliance is. Very large M&A deals can easily be upended just because of the mess that is involved in trying to unsort 409A problems if the founders were lax in handling these issues.
There is also a practical pointer to note. Let us say you are at a later stage and you want to be “aggressive” with pricing (not bad faith, not fraudulent, just aggressive) in order to incentivize key people to join your venture. Well, you can’t chance it with options because the penalties under 409A are just too high. But you might choose to grant restricted stock instead since 409A does not apply to such grants. Of course, other issues then arise.
You must buy restricted stock up front. Paying $200 at formation is one thing but, even using aggressive pricing at later stages may still leave recipients having to pay sums such as $20K to get such stock. If, however, the recipients are willing to take the economic risk, it is possible for a board to do restricted grants, to accept payment in the form of a full-recourse promissory note from the recipient promising to pay such note in four or five years, and to try to structure a deal accordingly.
This is by no means an ideal scenario and typically requires professional help to deal with the issues but it is a possible way of structuring incentives more favorably to key people without exposing them to the outsized risks of 409A.