From very early on, one of the distinguishing features of the Silicon Valley school of innovation was the notion that virtually every one on the team – from the receptionist at the front door to the founders in the corner office – should have a stake in the success of the venture.  While founders and in some cases other very early employees often acquired their “sweat equity” in the form of common stock, most later employees got their “upside participation” in the form of options to purchase common stock – typically at a price substantially less than the price paid for shares of preferred stock by more or less contemporaneous venture capital or other sophisticated investors.  How much less?  Well, therein lies a tale; alas, an increasingly frightening tale in recent years.

By way of background, in the good old days of sweat equity pricing – say, before 2004 (more on that later) – the task was in principal more or less what it is today.  The option exercise price was supposed to be set at the fair market value of the common stock on the date the option was granted.  The “technical” problem of figuring out fair market value was as much ritual as science: the process typically culminated in a boilerplate board resolution that implied a timely, exhaustive, good faith effort by the board – that in reality was mostly driven by rules of thumb.  Among those rules, the “common is worth 1/10th the preferred at the time of a first round venture financing” was one of the most popular.  Life was more or less good for founders, employees and investors alike.  As for the IRS, well, if you stuck to the rules of thumb and backed it up with the appropriate boilerplate, the IRS generally looked the other way.

And then came 2004, and Internal Revenue Code Section 409A, and the game was up.  Valuation rules of thumb were out (bad enough) and the cost of getting it wrong went way up (much worse).  Whereas in the good old days a board could be pretty confident that using a rule of thumb to set the valuation (albeit dressing it up in the board resolutions) would keep the IRS agents away, these days a board often does considerably more than that if it wants to sleep well at night, IRS-wise.  First, because 409A essentially eliminated using rules of thumb to determine fair market value in favor of some very particular – in terms of factors to be considered in setting a valuation and who should do the considering and how often – guidelines.  Second, because the cost of getting it wrong (in the old days mostly theoretical if occasionally somewhat problematic from an accounting perspective in an exit transaction) went up.  Way up.  For the employee, the company, and potentially even the individual members of the company’s board of directors.

Okay, first to the valuation question.  409A provides (in broad substance: this blog is a business heads up, not a comprehensive or even summary legal analysis) a specific list of factors that must be considered in making a valuation determination.  It also provides specific criteria as to who can do the valuation analysis if you want the IRS to take it seriously.  Alas, for most venture-backed companies the folks that qualify under the criteria are generally independent,  appropriately experienced, and expensive (say $5k to $50k depending on stage of development of the business and complexity of the capital structure) professional appraisers.  Follow the rules (i.e. absorb the expense) and you can be reasonably (if not totally) certain that the IRS will find better ponds to fish in than yours.  Don’t follow the rules, and ….

What can happen if you mess up a 409A valuation?  It’s not pretty.  Let’s take a hypothetical, and to make it both simple and less scary, let’s start with what happens if an employee is granted a vested option to purchase a single share of common stock at an exercise price of $1.00, and that the IRS later (say 12 months later) decides the fair market value was $3.00.  Well, first the employee is on the hook for not paying federal and state taxes on the $2.00 difference between the option exercise price of $1.00 and the IRS determined fair market value of $3.00.  Oh, and on top of that a 20% penalty tax and likely interest.  (And in some states, like California, an additional 20% penalty.)  And the company – and if the company can’t come up with the money, the various directors of the company personally – are on the hook for the unwithheld withholding taxes on the $2.00 – over and above the cost of redoing the accounting books to reflect the added compensation expense.  Ugly, indeed.

And, of course, it gets worse.  Because in most cases stock options vest over time; that is, an award of say 1,000 option shares might vest over four years.  At each vesting date, figure out the difference between the exercise price and the then fair market value and repeat the calculation for the shares that vested.  Even uglier.

So it looks like directors of venture backed companies that want to sleep well at night need to comply with 409A, such compliance most likely to include spending scarce corporate cash resources on periodic (at least every 12 months, and in many cases more often than that) professional appraisals of their common stock.  Among the prices we pay, I guess, for living in a post-Sarbanes-Oxley world.

An important footnote.  Some entrepreneurs and investors take the view that the fair market value exercise price problem posed by 409A can be avoided by simply setting the option exercise price at least equal to the then preferred price.  That’s true, if perhaps too clever.  If you live someplace where likely employees don’t understand the value of having an option exercise price below the current investor preferred price, well, good for you (not really, but that is another story).  Except that if you ever find yourself needing to bring on board a key player who does understand the difference you are going to have a problem figuring out how to explain to everyone else why their options are priced higher than the new guy’s.