If you are not familiar with Internal Revenue Code Section 409A, it generally requires startups to price their stock options at fair market value. (Technically it is only a requirement to satisfy Section 409A’s exemption for stock options, but not satisfying the exemption burdens the option with restrictions that make it unworkable in most cases.)
If a company grants a stock option with an exercise price less than the fair market value of the underlying stock on the date of grant, the optionee is taxed and owes penalties and interest as the option vests. In contrast, an optionee is not taxed on an ordinary stock option priced at FMV until exercise.
Although the IRS regulations do not require companies to obtain third party valuations, they heavily encourage it. If companies choose not to hire third party valuation firms, they have to use a “reasonable valuation method” in pricing their stock options. Section 409A is a headache for startups that makes their life more difficult.
I suggest that Congress repeal Section 409A for the reasons set forth below.
Top 7 Reasons To Repeal Section 409A As It Applies To Startup Stock Options
1. It makes life more difficult and complex for startups. Why would we want to do this to the most productive segment of our economy in terms of creating jobs?
2. It makes it harder for startups to share equity with workers because companies have to take time to undergo a valuation analysis before issuing options. Before 409A, companies had more leeway; more freedom to operate without fear of adverse tax consequences to the worker. In other words, Section 409A is anti-worker. Why in this day and age would we want to make it harder for employers to share the pie with workers? Shouldn’t our policies be pro-worker?
3. Section 409A causes businesses to incur bureaucratic expenses and suffer bureaucratic delays (while they go get 409A valuations and undergo a valuation process by themselves). Again, why would we want to do this to the most productive segment of our economy when it comes to creating jobs?
4. It doesn’t make sense to apply typical valuation models to startup companies. Startup companies are frequently concept stage companies. At the start, they are always pre-revenue. How do you value a concept stage company? The answer–it is a guess. It does not make sense for the law to require these companies to go through a valuation process that would be appropriate for mature companies, but for which the concepts do not even begin to fit for early stage companies.
5. It creates tax uncertainty for workers. If a company determines the FMV of its stock is $1.00 a share, and grants stock options at that price but the IRS later determines that the company was wrong, the worker could suffer a tax hit, plus penalties and interest. Again, why do we want to makes life difficult for workers?
6. 409A may make sense as a public policy matter for companies that are paying large sums of money to executives, but startups frequently pay their executives little or no money. Plus, what we are asking for here is to repeal Section 409A as it applies to stock options.
7. Life is about to become a lot harder for startups in a number of different ways. The SEC is about to issue final “bad actor” regulations that will make it a lot harder for startups to raise capital. The SEC is also about to issue new accredited investor verification rules that will also make it harder on startups to raise money. We need to reduce the regulatory burden on startups. Repealing 409A as it applies to stock options will help that.
Proposed Legislative Fix
A new Section 409A(f) shall be added to Section 409A to read as follows:
“This section shall not apply to issuance of options that are from a business entity the aggregate gross assets of such business entity immediately after the issuance of the option does not exceed $50,000,000.”
Life is already too difficult for startups from a regulatory/legal compliance point of view. Let’s repeal some law to make it easier.
The next time you are talking to one of your Conressional representatives, and they tell you–”Be specific. I need specific ideas!”–tell them this:
“Repeal the second sentence of Section 201(a)(1) of the JOBS Act.”
It is the second sentence of Section 201(a)(1) of the JOBS Act which has hung up implementation of one of the most important provisions of the JOBS Act–the provision that would have allowed startups that were raising money from only accredited investors to generally solicit investments. I have quoted in bold below the specific, offensive provision.
Theoretically, it would not have been too difficult for the SEC to implement this provision. However, it has proven to be. But the bigger question is—why do we need to wait for regulations to be issued at all? This whole idea that we need regulatory agencies involved to make a straightforward change in the law–we need to dispel that notion. We don’t need regulatory involvement. Statutory changes alone, that don’t call for regulatory agency involvement, and that in fact discourage or prohibit regulatory agency involvement–that is what we need.
Want an example of what I am talking about? The JOBS Act didn’t call for the SEC to issue guidance on the angel group exemption from broker-dealer registration, but the SEC issued a Q&A anyway that interpreted the provisions in an extremely narrow and unhelpful way.
The underlying problem here is that the SEC doesn’t like the idea of companies being able to generally solicit for funds. The SEC is troubled by the policy decision that Congress made. And to be fair to the SEC, the Congress could have been clearer in its mandate to the SEC (again, quoted below).
In any event, the next time you talk to your Congressional representative, could you please tell him or her to introduce a bill to repeal this sentence?
(a) Modification of Rules-
(1) Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors. Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission. Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under section 4(2) of the Securities Act of 1933 (15 U.S.C. 77d(2)).