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.