Guide
What happens if you grant options without a 409A valuation
Updated
This matters because of who pays. It is not the company that skipped the valuation but the employee holding the options, often on stock they cannot sell.
Question 1
What are you granting?
Section 409A bites on stock rights whose exercise price is below the fair market value of the underlying stock on the grant date. Not every equity award raises the question.
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What the statute does
Under 26 U.S.C. 409A(a)(1), a nonqualified deferred compensation plan can fail the requirements. Then all compensation deferred under it for the taxable year and all preceding taxable years is includible in gross income. That applies to the extent it is not subject to a substantial risk of forfeiture.
The tax is then increased by two things. One is interest at the underpayment rate plus one percentage point. The other is an amount equal to 20 percent of the compensation required to be included in gross income.
409A and stock options: how an option becomes deferred compensation
A stock option with an exercise price at or above the underlying stock's fair market value on the grant date is generally not deferred compensation here. Granted below that value, it can be.
That is the whole mechanism, and it explains why the valuation is the control. The valuation does not create the protection by existing; it creates it by establishing, inside a presumption, what fair market value was on the day of the grant.
Why it surfaces in diligence
Because a buyer's counsel asks for the cap table, the option grants, the board approvals and the valuations, and lines them up against each other. It is one of the first things checked and one of the easiest to check.
Discovering it then is the expensive version. It arrives at the other side's point of maximum leverage and affects employees about to have a good day. People who did not create the problem fix it under time pressure.
The two things to do today
Stop granting until a valuation is in place. Continuing to grant while the position is being investigated adds to the exposure at the rate of one grant per hire.
Assemble the record: every grant date, every board approval or written consent, every exercise price, and the valuation relied on for each. That document is the first thing any adviser will ask for, and building it is work you would have to do anyway.