Just How Bad is 409A Non-Compliance for a Startup, Really?

September 22, 2015 Hannah Bloomfield

In the decade since IRC 409A was enacted, people have debated whether or not startups really need to comply. Valuation firms have emphasized a host of negative consequences for non-compliance. Others have argued that it doesn’t matter and that valuation firms are merely engaging in self-serving fear mongering. But who’s right? 

Most entrepreneurs hate 409A. They justifiably feel that the government has imposed an arbitrary, costly regulation on companies that already struggle to survive. The odds of success seem low enough without the government requiring companies to spend thousands of dollars annually on 409A compliance.

Most industry experts feel that the target of 409A regulations is larger companies anyway, and that smaller companies (especially startups) are simply collateral damage.

And just what is the value that 409A valuation firms create for the thousands of dollars they receive? Do you really believe that they know the value of your company any better than you do? The situation gets even more bizarre when valuation firms themselves readily admit that valuing the earliest-stage startups is notoriously unreliable and subjective.

Furthermore, you may have heard that 409A doesn’t even apply to Incentive Stock Options (ISOs), which comprise the vast majority of startup option issuances. You may have also heard that you only need to make a “good faith” effort to set the strike price of your ISOs at fair market value. But “good faith” sounds pretty easy.

So why can’t you just ignore all of this and save your company a lot of money?

Well, you can.

However, like all things related to taxes, getting to the right answer for your company is complicated, and the costs of a mistake could be high.

Opinions about 409A (and all IRS tax issues) seem to follow the graph below.

 

Mount-stupid

 

To simplify the problem for you, we offer you our best recommendation based on years of experience as entrepreneurs, investors and valuation professionals, and through hours of discussions with lawyers, accountants, etc.

However, we welcome feedback to this article and will make revisions if any of our assertions prove incorrect.

Our Perspective in a Nutshell: A Brightline Recommendation

Based on years of experience on many sides of the debate, we have a simple answer to your problem.

If your startup meets any of the following triggers, you should pay for a 409A:

  • Your company has found a source of consistent revenue
  • Your company has raised more than $500K
  • Your company has issued preferred shares or raised money through a convertible security (like a SAFE, KISS, or convertible debt)
  • Your company reasonably anticipates an IPO in the next 180 days or an acquisition in the next 90 days
  • Some shareholders have already sold their stock (as opposed to the company issuing new stock–i.e., secondary transactions not primary issuances)
  • Your company has more than $100K in assets

If this is your situation, there are plenty of inexpensive, high-quality, and low-risk 409A valuation compliance options available to you.

You can also use this data-driven 409A guide and infographic to guide you along the process.

If none of the above bullet points apply to your company, then you have a free-option that’s really easy to use. We have written more about the free option here, explaining why it’s worth consideration.

Our recommendation is based on the fact that the chances of an IRS 409A compliance audit become more and more remote the earlier stage your startup is. But while the chances of an audit may be remote, the cost of the audit itself and the costs of non-compliance are potentially huge.

409A Compliance Is Like Insurance

It turns out 409A valuations are a lot like insurance. Most people don’t buy “lightning-strike insurance” because the risk is so astronomically small. However, a lot of people do have life insurance for two reasons: 1) the risk, though often small, is still meaningful and 2) the costs of death for many families is really high.

In probability theory, this is captured by the concept of expected value (EV). The EV of an event is the likelihood of an event happening multiplied by the value (net cost or benefit) you would receive from that event.

Our belief is that 409A non-compliance risk falls into the difficult category of having a very-low likelihood of happening but a really high cost if it does.

Let’s look at both the probability and the cost, starting with the costs.

The Costs of Non-Compliance Aren’t That Big of a Deal, Right?

Just what are the costs of 409A non-compliance? We can see this through a pretty simple example.

Let’s say you grant Sally, your newly hired CTO, 10,000 incentive stock options at $2 / share with vesting over 4 years. You just literally “guessed” when you set the strike price at $2.

3-years down the road the IRS selects your company to audit. They take issue with your valuation and say the valuation should have been $3 / share. Further, they believe that your company is currently worth $30 / share.

What are Sally’s costs in this situation?

It turns out that they are really nasty:

  • Immediate Ordinary Income Tax. Sally will be taxed this year on the spread between the company’s current FMV ($30 / share) and the incorrect grant FMV at ordinary income rates (say 40%): 40% * ($30-$2) * 10,000 = $112,000.
  • 20% Penalty. Plus Sally will owe an additional 20% on the spread as a penalty: 20% * ($30-$2) * 10,000 = $56,000
  • Interest. Sally will also likely owe interest on the underpayment amounts. This calculation is too technical for this article but it could easily add another meaningful payment.
  • Payment owed as security vests. It gets worse. Sally will owe this payment as her shares vest, not when she actually sells her shares. If she can’t find a buyer, she could have a huge tax bill on a paper gain without being able to get liquidity to finance it.
  • Company-wide problems. Sally alone could owe $170K+ in taxes but you probably didn’t only grant shares to Sally using this incorrect valuation, you may have granted shares to scores of people. The impact could be 20x+ what we have quantified.

Several people have proposed that the costs may not be as high due to several potential loopholes in the regulation.

There may be some gray area, it is true, but experience suggests that trying to cheat/beat the IRS is at best, a risky strategy and at worst, downright stupid. Let’s consider a few of these “loopholes” below.

Limiting Factors and Questions about the Example

Since the company granted Sally ISOs, the regulation of her shares wouldn’t fall under 409A. Therefore, she wouldn’t be subject to these penalties right?

Wrong. ISOs that are granted below fair-market value become NSOs in the eyes of the IRS which are subject to 409A regulations and penalties.

Couldn’t the company just modify her grants retroactively to eliminate this problem?

The company can make some modifications but unfortunately any modification except for the extension of the option’s term is treated as a new grant.

OK, big deal, so the company issues her new grants, right?

Wrong. First, we aren’t sure that the IRS is going to just ignore the fact that the previous grant was in violation of 409A for 3 years.

However, even if the IRS chose to ignore this, there are huge costs to re-issuing these grants:

  • The exercise cost of these grants will be $30 (the current FMV) as opposed to $2. This alone makes the options worth a fraction of what they were when they were originally granted.
  • Accounting and financial statements prepared based on the old grants will need to be restated.
  • The company will incur significant legal and valuation fees as it re-issues all of these options.

Why doesn’t Sally just exercise her shares so that they become common stock and then these penalties don’t apply?

Sally can exercise the vested portion of her option grant, but all the above taxes and penalties still apply to those shares.

And Sally can’t legally exercise her unvested shares until they vest, unless the grant happened to be early exercisable. Assuming she doesn’t have this right, she must wait to exercise until they vest.

So exercising her options doesn’t decrease her costs as 409A penalties and taxes accrue as options vest and not at exercise. In theory, an employee could have to pay all the taxes and penalties without ever even exercising a single share.

Changing the options to make them early exercisable will require that the options be re-issued with all of the problems mentioned above.

The Probability of 409A Non-Compliance

In our view, the probability of the IRS successfully proving that a startup has violated 409A is fairly remote. As stated above, the IRS has not taken action against a single startup in the ten years since the law’s inception. Further, the chances rapidly converge on zero the closer your company is to inception.

Several factors make this unlikely:

  1. The IRS has only just begun inquiries about 409A compliance (directed at large companies) and has never brought an action against a startup in the 10+ years since the regulation became law.
  2. The IRS would need to select your company among hundreds of thousands of potential offenders based on the probability of succeeding.
  3. The valuation standard that would apply would be that your valuation was either “grossly unreasonable” or that you didn’t make a “good faith” effort.
  4. Proving that your valuation was wrong will be incredibly hard the earlier the stage of your company.

Many early-stage companies have no financial results, no revenue, and no operating history. They are basically just an idea and some articles of incorporation. Justifying any positive valuation for these companies is tenuous, let alone proving that somebody else’s valuation is too low.

Overvaluing your company is “safer” because the IRS is concerned about low valuations. But many valuation experts would assign very low valuations to the earliest stage startups. So if you come to a reasonable and relatively “high” valuation (as compared to zero), it seems almost impossible that the IRS could prove an error.

This isn’t true for later-stage companies. The larger and more mature your company becomes, the easier it is to justify an objective valuation, and there is a greater risk of a 409A audit as larger companies actually have money for the IRS to come after.

For companies at any stage, even if the IRS never audits your company, the more pressing and likely “audit risk” is probably that of your accounting or audit firm. Regardless of whether or not the IRS has ever taken action related to 409A, CPA’s are obligated to provide an opinion according to the letter of the law. So if the IRS doesn’t hold you to the standards, your accountant probably will.

On this point, I am not speculating, as I personally know companies who improperly valued their options and were forced by their auditors to reprice them. This meant going back and paying for MORE 409A valuations, reissuing all the option paperwork with a higher strike price, and then scraping together the cash to compensate optionholders for their loss.

All that being said, the most real and pressing risk related to 409A doesn’t actually come from the IRS. It comes from the Securities and Exchange Commission (“SEC”). While the SEC isn’t necessarily tasked with enforcing 409A, they will grill you about what they call “cheap stock” issues.

When filing for an IPO, the SEC thoroughly scrutinizes the company’s financial statements and disclosures. If they find evidence that options may have been granted below fair market value, the IPO process will be much more difficult.

But again, very few startups ever make it to an IPO. And the heaviest scrutiny is placed on options granted in the 12 months prior to filing, so 409A valuations at the earlier stages likely receive little attention.

Conclusion

409A compliance is kind of like buying insurance against the equivalent of a “zombie apocalypse” for your company. While the probability of a “zombie apocalypse” is remote, the damage would be astronomically high if it actually happened.

This puts early-stage startups in a painful and awkward situation. They can refuse to pay for a 409A valuation, use some good estimation methods, get to a reasonable valuation, and probably be just fine. However, if they are wrong, the costs are really painful.

Our suggestion is to pay for a 409A if you meet any of the brightline triggers mentioned above. Otherwise, you should consider using Shareworks Startup Edition's free 409A calculator. For the risk-averse, you can always pay for a low-cost 409A even at the earliest of stages.

About the Author

Hannah Bloomfield

Hannah Bloomfield started as a content marketing manager with Shareworks Startup Edition. Her experience with equity compensation stems from direct interviews and research with top experts from Shareworks by Morgan Stanley. She has since moved into a marketing program role working directly with our Global Private Market team to bring the most recent and relevant information on equity to the world's top private companies.

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