Does 409A Apply To ISO’s?

I just received a memo from a name-brand Silicon Valley law firm in response to a board discussion that I was part of about 409A (the company granted some options today, obligatory 409A discussion ensued.)  While I’m sure the law firm in question was trying to be helpful, the first paragraph of the memo says “But section 409A does not apply to Incentive stock options, or “ISOs”.  Grrr.

While this may be factually correct, it’s a logically false statement.  The memo goes on to correct this notion on the bottom of the second page, ending with “Therefore, it will be advisable in the future to use care when valuing Common Stock, regardless of whether the options being granted are ISOs or NSOs.”  Ok – thanks – but most entrepreneurs aren’t going to read past the first page!

I sent my lawyer friend the following note:

I’d like to suggest that the statement that 409A does not apply to ISO’s is misleading. While you clarify the dynamic later in the memo, a number of people (including lawyers, VCs, and entrepreneurs) have insisted that 409A doesn’t apply to ISO’s, so you don’t have to do anything to comply with 409A except grant ISOs. Obviously the conclusion being drawn by some is completely false and the concept is self-referential – if an ISO is granted below FMV, it no longer qualifies to be an ISO, becomes a NSO granted below market, and is subject to 409A. I don’t know if you have any influence on the way this memo is written / presented, but I’m personally tired of explaining to people that – in fact – ISOs are part of the discussion given that to be an ISO, they have to be granted at FMV, the determination of which is linked directly to 409A. Of course – I’m not a lawyer – so while I can’t include IRS Circular 230 in my emails about this, this is just my opinion and shouldn’t be relied on for anything by anyone.

  • Ben

    The December 23rd notification that private companies do not have to use an outside firm seems to have made this easier. I went through this in 2 board meetings in the last week and in both it was a 2 page memo from the CFO and we were done. Funny thing was in both cases it resulted in a lower estimated valuation than the 10% rule we all use.

  • Ben – I think someone has given you poor information or advice. While the 12/23 memo has helped some (by making clearer that options granted prior to 1/1/05 are “ok” as long as the board acted in good faith in determining FMV), it has nothing to do with saying “private companies don’t have to use an outside firm.” I talked about that in this post –

    The ability for a company younger than 10 years old to take the private company exemption and use an internal person to create a written valuation report detailing the accurate pricing of the common stock is not a new option – Unfortunately, in my opinion, it is not a good option at this point as the burden of proof for the valuation remains on the company and the legal language around this requirement is both ambiguous and dicey. Having an outside valuation done by a qualified party shifts the burden of proof to the IRS, which makes things dramatically safer for the company – and more importantly for the employees.

    There are two separate philosophies floating around venture funded companies right now. One is “don’t worry about it too much.” Unfortunately, the person that ultimately gets screwed in this case is the employee and I think – as a result – that’s a really bad judgement call on the part of the entrepreneurs and the board, especially in an early stage company where equity upside is a meaningful portion of the future value.

  • Scott

    By characterizing the statement “409A does not apply to ISOs” as misleading based on your nearly correct assertion that FMV strike price valuation is an ISO prerequisite, you may actually be spreading a more insidious misinformation. Assuming an option meets the IRC Section 422 test for ISO status, the option is expressly exempt from 409A. You contend that relying on the ISO exemption is a false sense of security because an option can’t be an ISO unless it’s granted at FMV. “AH HA!,” you exclaim at these “reputable” (albeit, momentarily “absurd”) lawyers, “the ISO FMV requirement brings your right back to the 409A valuation rules!” Fortunately for my absurd colleagues, your statement is only nearly correct. Yes, an option must be granted with a FMV strike price in order to qualify as an ISO. However, if the option meets the other ISO requirements, the issuer still gets the benefit of the ISO “reasonable board” valuation presumption. As is often the case in such matters, the difference between being nearly correct and entirely correct is three years of law school.

  • Scott – While you are correct that I have not attended 3 years of law school, my co-writer Jason Mendelson, who is our general counsel has

  • Scott

    Brad – My quarrel was not with whether or not a private company could find itself in the post-409A enviable position of granting only ISOs. Rather, my quarrel was with your suggestion that any lawyer who made the statement “ISOs are exempt from 409A” was either misinformed or sophistical. The plain fact is ISOs are exempt from 409A, and an issuer need not concern itself with jumping through ambiguous and expensive valuation hoops in order to grant an ISO. The “good old days” still apply to ISOs. As for those companies who find it necessary to grant FMV NSOs, there are far more efficient strategies for escaping 409A than hiring a CPA or investment banker to throw darts at a dart board, photocopy it and sell it to the company for $40K.

  • Scott – I’m going to have to respectfully disagree with you – “the goold old days” simply do not apply to ISOs and I (and most lawyers I’ve talked with) believe that while the rules technically exempt ISOs, the commentary in my post above applies.

    In addition, the pricing for outside valuations is no where near $40k. The vast majority of proposals we are seeing and valuations that we are having done are coming in between $5k and $10k for the valuation analysis (2005 and 2006 to date of the valuation) plus another $5k for quarterly refreshes for the next 12 months. Since there is still significant uncertainty as to how the final rules are going to play out, this seems like a small price to pay to be on the conservative side of the equation.

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