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.