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Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

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409A – Mythbusters

Comments (5)

Perhaps the only upside to the 409A panic in the start up world has been some of the urban legends that have already popped up. Jason and I aren’t your lawyers, so don’t take this as formal advice, but if your lawyers are advising you of the following, at least ask some questions. We’ve personally heard some senior partners at big-name law firms say some crazy things regarding 409A. The following are actual quotes. We will not disclose names to protect the innocent, er.. guilty.

“ISOs (incentive stock options) are exempt from 409A, so don’t worry about it, just grant ISOs.” : This is perhaps our favorite statement. In fact, the statement is factually correct, but logically stupid. In order to qualify for ISO status, the grants must be made at fair market value or higher. Given that ISOs cannot be given to consultants, nor are most executives eligible for ISOs, no company will ever get by granting just ISOs. Since NSOs (non qualified stock options) are subject to 409A, there will be some sort of formal valuation report (whether done internally or by a third party) that will determine the fair market value of the stock, which will in turn determine the price of the ISO. In other words, 409A does affect ISOs.

“Restricted Stock is exempt from 409A, so don’t worry about it, just grant Restricted Stock.” : Another factual statement that may work for very early stage companies but just doesn’t work in reality for most companies. When a restricted stock grant is made, the award itself is a taxable event and the grantee immediately holds voting stock. Perhaps granting restricted stock awards to the first half dozen employees of a company when the valuation is extremely low works, but for any somewhat mature start up, this doesn’t make much sense. Note that Restricted Stock Units and other deferred compensations units are subject to 409A. There are some workarounds for 409A, but they are pretty dense and confusing. For example:

“Such units will not be subject to Section 409A if settled (whether in stock or cash) before the later of (i) two and one half months after the end of the employer’s fiscal year in which vesting occurred, or (ii) March 15 following the calendar year in which vesting occurred. If the units qualify as performance-based compensation under Section 409A, the holder may make an initial deferral election at any time prior to the last six months of the performance vesting period”

See, we told you so.

“Directors are personally liable for screw ups concerning 409A.” : Jason was pelted with calls on this after a name-brand firm went around telling its clients this. Frankly, we aren’t sure where this is coming from, because there is nothing specific in the regulations which say this. Our best guess is that this stems from improper withholdings that are associated with 409A blunders. Should the company undervalue its options and therefore subject the employee to income on the spread versus the true fair market value, the company should also make withholding payments to the IRS on this “income.” Traditionally, failure to properly withhold for taxes can be a personal liability of officers and directors, so perhaps this is the chain of thought that elicited this statement. In our opinion, we’d be very surprised if the IRS chose to prosecute except in the most egregious situations, so we aren’t losing any sleep over this.

While writing this, the trailer for the season premier of 24 just aired and we’d rather think about all the dudes Jack Bauer kills this year instead of 409A, so we are done with this post.  Don’t worry – we’re also almost done with torturing you on 409A.

  • http://www.feld.com Brad Feld

    I received – via email – a good comment from someone who wanted to remain anonymous concerning potential director liability from 409A. Following are the two points he brought up.

    1. Tangential risk of liability from the IRS for improper withholding.

    2. Risk of lawsuit from an employee who was granted an option at a discount. The claim would be (a) I was enticed to work for Newco because of the promised option grant, (b) I was told that my grant would be at FMV, (c) I was audited and the IRS says my grants was not at FMV, (d) the board set my exercise price and “knew or should have known” that the exercise price was less than FMV, (e) the board is liable to me for the additional taxes.

    #2 is a real stretch, but you can imagine that someone might bring a claim like this.

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