While I was on vacation, I got an email from someone much more “in the know” than I am that it is highly unlikely that the final 409A regulations will be finalized in time for them to be effective by 1/1/07. Daniel Hogans – attorney-advisor in the Treasury Office of Tax Policy – stated during a speech at the American Law Institute-American Bar Association’s meeting last week that the proposed regulations’ effective date of Jan. 1, 2007, is “increasingly unworkable at this point.” People can “reasonably expect to see additional guidance” on the effective date issue. Hogans said he did not expect structural changes in the final regulations, but there will be changes in the details.
Archive for the ‘409A’ Category
Just when you thought you’d never hear from me and Jason on 409A again, we received the following missive from a lawyer friend of ours:
(The) IRS is now saying that drafting final regs is too hard and that they won’t be out until late summer/early fall. That translates into September/October in my head. Apparently they’re having issues with putting together startup valuation rules.
Well, at least we don’t feel so stupid now thinking that complying with 409A is an almost impossible task. As previously stated in our 409A series, the idea of coming up with any “real” private company valuation is, at best, a shot in the dark. Nice to see the IRS struggling with a monster of its own making.
We can’t wait to see what guidance they come out with.
Jason sent me a quote that was on the first slide of a 409A presentation from one of the major law firms we work with.
“409A is the tax law that ate the world. Every day we discover another 12 issues.”
—– Senior US Treasury Department Tax Official, March 13, 2006
Maybe Jack Bauer will start paying attention to 409A in tonight’s episode of 24.
I guess it is only fair that while Jason and I rip on the IRS, accountants, and lawyers regarding 409A, we make take a few shots at the VC community. VC’s are perhaps the most uninformed population with respect to the 409A guidelines. In general, it’s been very disappointing to here other VCs speak about the regulations and make grotesque over-generalizations regarding their applicability. At this point, I can’t remember how many “this isn’t right” emails that I’ve had to send. At least I have a blog that I can send them to (of course – not for “official advice”), as opposed to having to type the same email 100 times.
Following is an example that came up last week that made my head spin. One of our companies – a relatively young one that has only had one round of financing - is in the middle of raising a new financing. They are doing well, have a competitive financing situation going on, and I expect they will have multiple options to choose from. The company is well informed about 409A, has done all the things you’d expect them to, and are planning to have an outside audit done by the end of April. The financing is expected to close by the end of March – they are holding off on the 409A audit to wait for the financing to be completed. They have decided to hold off granting any new options until after the financing and have accepted that the option price will be driven by the 409A audit based on the new preferred stock price associated with the financing.
One of the VCs they are talking to has asserted that they cannot close a financing without an outside audit. The assertion from the VC is that “it’s too risky and creates too much liability for the new investor.” Huh? In addition to being a completely illogical statement, it’s clear the VC simply doesn’t understand 409A since holding off on the financing will likely drive the value of the common stock down (since the company is running out of money) while doing the financing will drive the value of the common stock up (since it’ll be well-financed at a higher per share price then before.) Which is a more conservative position to take? Actually, it doesn’t really matter – since it’s an early stage companies we are likely talking about pennies a share in any scenario.
Add one “point” to the “noise” column under 409A. It blows my mind that major business decisions (e.g. the financing of an early stage company) are being driven by the IRS guidelines. Shame on you IRS, but more shame on the VCs who remain ignorant about the real facts.
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.