409A – IRS Update – Maybe The Sky Isn’t Falling

On Friday, Jason and I received an early Festivus / Hanumas gift from an attorney who asked to remain nameless, but we thank him nevertheless. He clued us in to a release from the IRS on December 23rd where the IRS issued some additional guidance related to prior grants. In a nutshell, the IRS said that stock option grants made before 1/1/05 are safe from 409A if they were done in accordance with the good faith valuation rules of the ISO regulations. Furthermore, grants between 1/1/05 and the effective date of final regulations just need to be done under a reasonable valuation method.

So what does this really mean?  Most importantly, it means that 409A is a moving target and the story is changing faster than we can crank out blog posts. We’ll wait for some of the “pundits” to decipher the IRS statements (ya gotta love how everything the IRS releases to give guidance usually causes even more confusion), but it looks like this is a step toward sanity. Best case, as long as the board of directors were doing good analysis of fair market values when making grants, then perhaps past grants (prior to 1/1/05) are effectively exempted out of 409A. This would be huge and welcome relief. See our prior blog on the official NVCA comment letter – this “grandfather” clause was one of the major tenets of the letter.

As for grants done in 2005, this sounds pretty good but no one really knows what a “reasonable valuation method” means yet, so we’ll reserve judgment at this time.

  • Any opinions on what sort of impact 409a ‘compliance’ might have on pre-VC (pre-investment) start ups during DD? Seems like another hurdle for the startup.

  • Jason

    It’s a very good question. I think you are correct when you say there will be another diligence hurdle. Some VCs are going to be very nervous if they don’t see some type of formal report (at least internally) justifying the valuation of grants. Some may not care, but clearly if there is a 409A problem down the road, it’s going to affect the company and thus the VC’s investment. I don’t know yet what our firm policy will be, but I can tell you that simple board minutes that say “the board discussed and decided FMV is $X” is not going to cut it.

    Unfortunately, I think the other change that comes out of this is represenations in purchase agreements whereby the company represents it has complied with 409A. I think we’ll see this in the merger context too.

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