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Not surprisingly, some lawyers have suggested that Jason and I are now 409A experts and that we have been dispensing 409A advice. Nothing could be further from the truth – we are merely expressing our opinions as lay people affected by 409A about what we think is going on. Of course, since lawyers have written us, we feel compelled to clarify. Fortunately, the IRS gives us a way to do this, as follows:
Circular 230 Disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matter(s) addressed herein.
Of course, since I’m neither a lawyer or an account, this all feels a little silly. However, Jason is a lawyer and – well – he thinks it’s patently absurd. Now, if you want any advice on the best way to watch 24 on Sunday night, feel free to ask.
In the spirit of the New Year, I’m trying to blog the questions that I’m getting that I think could have broad interest. Here’s another one. Remember – I’m not a lawyer so this isn’t legal advice.
I have a question regarding the valuation of a startup I’m in and when it takes affect. When I joined the startup in 2004, I was granted options at $.10 each. In Oct ’05, we received a term sheet as part our financing efforts which valued the shares at a multiple to the $.10. We ultimately didn’t sign for various reasons. I have 2 questions related to this.
a) Does the event of receiving a term sheet automatically trigger a new price for the options based upon the valuation in the term sheet even if it isn’t signed? While a 409A valuation expert might take into consideration an unsigned term sheet as part of their valuation analysis (similar to them taking into consideration an offer to acquire the company at a certain price), this won’t necessarily trigger a new price for common stock (presumably the stock underlying the options – equal to the option strike price.) It’s likely the the new investment would have been preferred stock with some additional characteristics (liquidation preference, participation, dividends) that would cause the preferred stock to have a higher price than common stock. As a result, at the minimum, one has to take into consideration the capital structure of the company when determining the price for the stock options. It’s even conceivable – based on a formal valuation analysis – that the appraised value of the common stock might be less than $0.10 due to the new proposed capital structure, even though the per share price of the preferred stock that was proposed was a multiple to the $0.10.
b) Given there was lots of pre-work to come up with the pre-money valuation, when would this pre-money valuation take effect? Since the proposed investment was never consummated, this pre-money valuation doesn’t really ever take effect. It’s merely one data point in the determination of value under 409A (and – in my opinion – a relatively weak one since the deal didn’t occur).
For the lawyers and 409A valuation experts out there lurking, I encourage you to comments on / add to posts like these.
This is our last post on 409A until the IRS issues more guidance or accepts some of the comments it has received during the comment period. In other words, we are “done” with 409A until sometime between tomorrow and next year. While I was hoping to get to 10 posts so I could refer to this series as “My Top 10 Thoughts On 409A” to join in with the top 10 list of 2005 meme, we only made it to 9. We hope you’ve enjoyed this series (yes – that was sarcastic.)
To wrap things up, we have a couple of questions that we are asking ourselves these days in light of 409A.
How the hell will the IRS audit this? We have no clue how this will actually play out in the real world. Is the IRS hiring a bunch of private company valuation experts? If so, they are going to have to “pay up” as there aren’t enough of these types in the private sector, much less the public sector. Or maybe these will become new members of the Homeland Security Accounting Compliance Task Force (a newly formed task force that is overseen by the Office of Civil Rights and Civil Liberties.)
What will happen to the valuation reports? Given that valuation reports of private companies will contain a ton of confidential data, what will happen if an employee gets audited and requests the report to fight off the IRS? Does the company have a duty to give the report to the employee? Will the company have to expend resources and work directly with the IRS on a confidential basis? Will these reports “find” themselves out in the public? What about attorney client privilege issues? Mmm – yummy rat hole.
Will the IRS actually respond to any of the comments given to it? Jason has been active with the NVCA and the general counsel / COO group to provide comments and in addition many law firms and accounting firms are drafting their comments as well, but will this all fall on deaf ears? The idea of the internal valuation method being essentially “useless” could drastically change with the right tweaks to the regulation. We got an encouraging early Christmas present from the IRS and are hopeful for an early Easter present also.
Bottom line, have “fun” with 409A in 2006. There is a lot of noise in this area and hopefully we helped quiet some of it (or – at least made the noise more entertaining.) We’ll post periodically with updates as the proposed rules evolve.
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.
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.