Regulation 409A: Beware Buying and Selling Your Stock

Why do I care?

Regulation 409A is an IRS provision that regulates the treatment of “deferred compensation” from a company.  If you’re unsure what that term means, just think about the two ways a startup typically compensates its employees: salary… and you got it, stock options.

Specifically, 409A mandates that such deferred compensation have an exercise price at or above fair market value at the time of the grant.  If the exercise price is below what’s deemed fair market value, then the startup can face some fairly draconian penalties.  To ensure an accurate fair market value, the IRS prescribes two specific “reasonable valuation methods.”

Translation: when buying or selling your startup’s stock, you must make sure that the price is plausibly real.

How does it work?

Prior to 409A, pricing your stock options for sale was a relatively informal process that the Board of Directors dictated.  However, if startups wish to avoid issues and hold up under audit scrutiny, there are two valuation methods the IRS allows for:

  1. Have an employee of the startup who has “significant knowledge and experience or training in performing similar valuations” create a report setting the stock price and explaining the reasoning.  However, the definition of such knowledge is usually a topic of debate, not to mention that this puts a nice amount of liability solely on that employee.
  2. Hire an independent valuation firm.  However, these firms can be cost-prohibitive, with valuations coming from anywhere from $5-40,000.

If you’ve used one of these two methods, the IRS can only cause trouble for you if it can prove that the valuation was grossly unreasonable.  Again, another term left undefined.

So when do I actually have to get a valuation?

The correct answer here is also one of the most annoying you can receive: it depends.

The lawyer in me is obliged to recommend that you get formally valued within a few months of each selling or buying event.

On the other hand…

The businessman, realist and Lean Startup reader in me doesn’t quite agree when weighing the costs for a bootstrapping startup against the undefined standards that trigger an IRS audit and the resulting tax penalties.

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