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Yes. You do. That was easy. But perhaps we have gotten ahead of ourselves and we should start at the beginning of the story. While Section 409A is a tax provision, its genesis was the perceived abuse of deferred compensation arrangements by rapacious executives in the Enron and WorldCom debacles. Like the “golden parachute” rules of Section 280G, Section 409A is intended to work some good old-fashioned social engineering magic through the tax code. It was quite handy that these rules also made the IRS happy as Section 409A works in part by reigning in the ability of employees to “manipulate” or select the year in which they would have to recognize taxable income from various types of deferred compensation schemes. You see, the IRS does not like taxpayers to have any flexibility when it comes to the timing of recognition of income. Section 409A succeeded in achieving some of its narrow objectives but as is often the case, in ways that likely went well beyond the specific concerns that the statute was originally intended to address. The treatment of stock options under Section 409A is one of those unfortunate extensions. Regardless, we now have to live with these rules.

The problem with applying Section 409A to classic stock options is that the requirements of the statute typically cannot be satisfied. In other words, certain typical terms of a stock option that you and I are familiar with are fundamentally inconsistent with the requirements of Section 409A. Having said that, it is possible to create an option that is in fact compliant with the requirements of Section 409A but the terms of such an option would be very different from the typical terms that are often desired (e.g., the ability to exercise the option at any time after vesting is not possible with a “Section 409A compliant” option; instead, the option could only be exercised upon the happening of certain events such as a change of control or at a certain predetermined time). And what happens if a company grants non-compliant stock options? Lots of really bad things. For instance, the vesting of the stock option becomes a taxable event to the extent of the difference between the exercise price and the fair market value of the underlying stock even though the option is not exercised. But if that is not bad enough, an additional excise tax of 20% is applied on top of the ordinary income tax rate. And if you would like more, the options are effectively “marked to market” each year so the tax hit (including the excise tax plus interest back to grant date) keeps on coming each year thereafter as the underlying stock builds value until option exercise. Of course, there may also be a withholding obligation by the company that if not satisfied may result in personal liability for certain individuals on the finance side.  As I said before, lots of really bad things.

Given how difficult it is for a classic stock option to comply with the requirements of Section 409A, it is a good thing that the IRS regulations have granted exclusions from the application of Section 409A for certain stock options. For that reason, the vast majority of options are issued outside of Section 409A in reliance on these exclusions. Among other requirements, the exclusions allow an option issued with an exercise price that is at least equal to the fair market value of the underlying stock on the date of grant to fall outside the ambit of Section 409A. The good news is that this makes it easy to issue options that are not subject to the rigorous requirements of Section 409A. The bad news is that this puts an awful lot of pressure on making sure the determination of fair market value on the date of grant is spot on. This is easy in the case of publicly traded stock but very difficult in the case of a private company where determining the fair market value of the stock on any given date is more art than science. How can we ever really know whether the exercise price we set is really equal to the fair market value of the stock on that date? The short answer is that we cannot really ever know. And whatever you and I think it is, the IRS is always free to disagree. But the longer (and better) answer is that the regulations under Section 409A give us two possible safe harbors for private companies which, if complied with, will give us the presumption that our determination of fair market value is the fair market value and limit the IRS’s ability to disagree.

The first safe harbor (the “new company” safe harbor) allows for the company to value the underlying stock with a somewhat informal valuation but only if the company has been in existence for less than 10 years, has no class of stock that is publicly traded and the person preparing the valuation has at least five years of relevant valuation or similar financial experience in the same line of business as the issuer of the options. Often a board member or the CFO prepares this valuation report. The problem with this safe harbor is that it does not really define what the requisite degree of experience is; as a result, you can ever be sure that the IRS will accept the bona fides of the person preparing the valuation. For example, does the person have to have 5 years of doing purely valuation work or is it sufficient that they are an accountant who has some experience preparing or working with valuations but that was only a small part of what they did in their practice? This is why I generally shy away from this particular safe harbor since all the IRS needs to do to upset the apple cart is to argue that the person doing the valuation did not have the requisite expertise. What good is a safe harbor if it is based in part on satisfying a subjective standard? Not much of a safe harbor in my book.

The second safe harbor has no subjectivity built into it and therefore, is a “real” safe harbor. This safe harbor allows the company to rely on a valuation from a third party valuation firm that meets certain fairly objective standards. This is what is commonly referred to as the Section 409A valuation safe harbor and in my opinion it is really the only truly safe harbor. Once you receive the valuation, the regulations allow you to rely on that valuation for a 12 month period so long as nothing occurs during that period that would materially affect the valuation. For example, a subsequent financing round at a higher price per share, an acquisition or the development of new and valuable IP could be deemed to be material and might truncate the 12 month reliance period. A common question is whether an imminent financing at a higher pre-money valuation means you can no longer rely on the Section 409A valuation that was done 7 months ago. Unfortunately, determining what is a material change to the underlying value of the stock once again takes us into an area that requires judgment. While it is easy for me to say since it is not my money and there is always pressure to grant options at the lowest possible exercise price, when in doubt you should always get an updated valuation.

I recognize that the cost of a Section 409A valuation is not insubstantial, particularly for the typical cash strapped small emerging technology company. There is always a tension between incurring that cost and the downside if the option exercise price is determined using other means (including the new company safe harbor). But remember, the stakes are very high here. Guessing wrong on the valuation can have catastrophic consequences to the employees holding the options and could even tank a future sale or financing if a high degree of risk is uncovered in the due diligence process unless the suspect options are cancelled and reissued at a much higher exercise price which of course, would result in a large loss of value to the option holders. It is very unfortunate that small entrepreneurial businesses are faced with this Hobson’s choice especially since stock options were not the original target of Section 409A. But until Congress decides to roll back the reach of Section 409A or the IRS decides to amend its regulations to allow a kinder and gentler alternative that does not involve plunking down thousands of dollars on a Section 409A valuation, we are stuck in the soup with this one.