Section 409A of the Internal Revenue Code governs deferred compensation, including stock options, and imposes strict rules to prevent tax avoidance. Section 409A requires startups to obtain an independent appraisal of the company’s fair market value (FMV), and that appraisal is primarily used to set the strike price for employee stock options and comply with IRS regulations.
This process protects both the startup and its employees from significant tax penalties and legal risks that can arise if the stock isn’t priced correctly or appropriately documented. In addition, having a credible 409A valuation demonstrates financial transparency to investors, supports informed fundraising decisions, and provides a solid foundation for future equity offerings or exit events. For startups, failing to comply with Section 409A can lead to severe penalties, including immediate taxation, a 20% penalty, and interest charges for employees.
We’ve got a detailed guide to 409A valuations with more information, but let’s look at some of the common mistakes that startups make and how you can stay in compliance.
Common 409A Pitfalls for Startups
Some of the missteps that startups make with 409A valuations include:
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Incorrect stock option pricing
- If you grant stock options with an exercise price below fair market value (FMV), that can trigger tax penalties.
- Startups must set strike prices at or above FMV, as determined through a qualified 409A valuation.
- Example: If the fair market value is $20/share but options are granted at $15/share, employees would face immediate taxation on the $5 difference plus penalties.
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Outdated valuations
- It is a recommended best practice to update your 409A valuation annually, but it’s a requirement after material events (like funding rounds, mergers, or acquisitions), or you risk using obsolete FMV data.
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Improper documentation
- Lack of written agreements for deferred compensation plans or incomplete valuation records can leave startups vulnerable during IRS audits. Your final 409A report should clearly outline the data collected, the valuation methodologies used, and the calculations and reasoning behind the value conclusion.
- You must also document any deferred compensation plans, including the terms of deferral, payment and vesting schedules, participant eligibility, and any amendments you make over time.
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Ignoring risk factors
- Overlooking business-specific risks (e.g., market competition, regulatory hurdles) in valuation models can inflate a company’s fair market value and lead to overpriced options. It’s essential to use a qualified independent appraiser who’s knowledgeable about your industry.
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Deferred compensation traps
- Reducing founder salaries or delaying payments without proper structuring can accidentally create deferred compensation arrangements subject to 409A. So if your startup faces cash flow issues, and you agree to temporarily reduce your salary, you need to document the timing and form of payment, or you risk unintentionally creating a deferred compensation plan that could trigger Section 409A.
Strategies to Help Startups Avoid Penalties
Some of the best practices your startup should follow with 409A valuations include:
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Conduct regular 409A valuations
- Always use qualified third-party independent appraisers to perform your valuations. That provides you with IRS “safe harbor” protection.
- It’s a best practice to seek an updated 409a valuation after every material event, like a fundraising, M&A, or significant financial changes like drops in revenue.
- Understand valuation methods. For example, the income approach uses your forecasted future cash flows, and is very common for early-stage startups. The market approach compares your company to similar public/private companies, and is often used for growth-stage firms.
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Structure your stock options correctly
- Set your strike prices at FMV based on your documented valuation. For nonqualified stock options (NSOs or NQSOs), avoid dividends or discounts that lower the effective exercise price and can create immediate tax liabilities, penalties, and interest for the recipients.
- Incentive stock options (ISOs) are exempt from Section 409A only if the exercise price is at or above the FMV when granted and eligibility is limited to employees under a shareholder-approved plan. You also can’t alter the terms after granting the stock and you have to follow annual vesting limits.
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Maintain detailed documentation
- For your valuation reports, maintain detailed records of methodologies, assumptions, and appraiser communications.
- Your employee agreements should specify payment timing and conditions for deferred compensation to avoid ambiguities.
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Plan for material events
- Schedule new valuations in advance of funding rounds, product launches, or regulatory milestones to prevent rushed or non-compliant stock grants.
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Mitigate deferred compensation risks
- Avoid salary deferrals. If you’re reducing founder pay, document intent to repay within 2.5 months or tie bonuses to future milestones such as future funding rounds.
- If you use short-term deferrals, make sure the compensation is paid within 2.5 months of the tax year to avoid 409A classification.
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Leverage IRS correction programs
- If you do make mistakes, errors identified within two years can be corrected by resetting your option prices, though penalties may still apply.
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Remember the penalties for non-compliance
- Employees could face immediate taxation on vested options, plus a 20% penalty plus interest.
- The startup could lose “safe harbor” protection and face legal disputes.
Protect Your Startup with 409A Valuations
If you’re using stock options or deferred compensation at your startup, you need to be very careful about 409A compliance. You should prioritize regular independent evaluations, thorough documentation, and proactive planning for fundraising and other material events. A disciplined approach to 409A helps you avoid problems and penalties while supporting your growth and fundraising efforts.
