What to do when the 409A is changing

My company’s Slack lit up recently because of an announcement that we were going to be redoing our 409A valuation. If you haven’t been around the startup scene for long, there’s a good chance that that sentence sounds like Greek (or I guess pick your favorite language that you don’t know, if you happen to speak Greek). This is actually a really important process to understand, because it does have a lot of implications surrounding equity grants and decision-making around option exercises. Fortunately, it’s a relatively simple topic to get your head around.

What the heck is a 409A?

Section 409A of the US Tax Code sets the rules for companies surrounding “deferred compensation.” In particular, the type of deferred compensation that startups generally deal with are stock options. Compliance with section 409A requires a whole bunch of things, including establishing a valuation that can be associated with deferred compensation. The 409A valuation, which is sometimes referred to as the Fair Market Value (FMV), is established through engaging with an independent auditor who will determine the “true value” of the business for the purposes of IRS documentation.

It’s worth noting a couple really important details about the 409A valuation, which is that it’s the valuation for the company’s Common stock, and that it’s used to set the strike price for newly-issued grants of stock, options, RSUs, etc. Critically, company Common stock is not the same thing that investors buy, which is typically Preferred stock, which comes along with a whole bunch of other protections and bells and whistles afforded to investors, which means it usually costs a whole lot more than Common stock.

When does a 409A valuation change?

What a lot of people often don’t realize about the 409A valuation is that, legally, it has to be recomputed annually. A 409A valuation is only valid for a year, and the company has to engage with an auditing firm regularly to ensure that the valuation is kept up-to-date, and oftentimes, the valuation doesn’t actually end up changing at all, so lots of employees may not even be aware that this process is going on behind the scenes.

However, it does change sometimes. The most common situation that causes a 409A valuation to change is when a company raises a new round of funding. Receiving a terms sheet from a potential investor is a major financial event for a company, and the simple act of receiving a terms sheet, even if it is not accepted, actually invalidates the current 409A valuation, and necessitates a new audit to produce an updated valuation.

How does the 409A affect new employees?

When you join a new company, you’ll usually have some sort of equity package in your job offer. At earlier stage startups (let’s say Series A through Series D and sometimes Series E), you’re likely to receive a grant of stock options. At later stage startups, beyond Series E, but pre-IPO, there’s a good chance you’ll receive RSUs. At the earliest stage startups, who have raised Seed funding, or haven’t received any funding yet, you may receive restricted stock. I’m not going to get into what each of these different things are right now, but suffice to say that they all start off with some inherent value, according to the IRS. That inherent value is determined by the 409A.

In the common case of options, when the equity grant is approved by the board, new employees will receive paperwork that they sign to accept the option grant, which will say that they’ve been granted some number of options, which can be exercised by paying a strike price, and then the grantee will receive stock in exchange for the exercised option. That strike price will be pegged to whatever the 409A valuation was on the date of the grant. It’s worth understanding that once you’ve received an option grant, your strike price will never change – subsequent 409A valuations don’t modify your strike price, but they’ll determine the strike price of any new grants that you receive later on.

This ends up becoming a really important detail around funding rounds, because if you sign an offer letter before a funding round, but receive your option grant after a company has received terms sheets, you’ll actually end up with a different strike price for your options than the strike price the company may have referenced if you asked about the current strike price when you received the offer.

How does the 409A affect existing employees?

If you already work for the company, and you’ve been there for long enough to have vested some options that are now exercisable, the 409A is still an important thing to know about. As mentioned, it won’t change your strike price for option grants you’ve already received, but it does impact how much you pay in taxes when you exercise an option.

When you exercise an option, the IRS looks at a couple numbers. It says: “Ok, you had a strike price of $1, so you paid $1 per share as a cost basis, but the 409A valuation says this stock is actually worth $3 today, so we see that you have made $2 by exercising this option.” The IRS would like their fair share of that $2.

Now this is where things get tricky.

There’s actually two major types of option grants: Non-qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). If you exercise an NSO, the IRS is actually going to demand income tax on that $2, regardless of whether or not you have the ability to sell your stock. ISOs are a special type of option that full-time employees of a company can receive (contractors and advisors, for example, can’t receive ISOs), that have special tax benefits. If you exercise and hold an ISO, and don’t sell the stock you received in the same tax year, the IRS still treats those $2 as income, but only under the Alternative Minimum Tax (AMT).

Ugh. All roads related to ISOs inevitably lead back to talking about AMT. AMT is a stupidly confusing parallel tax system to the normal income tax that everybody is used to paying. Basically, there are certain types of income, where if you receive those types of income, you have to calculate your tax liability for not only the normal income tax system, but also this separate AMT system. The IRS looks at both systems, and charges you the larger of the two amounts. 

So if you joined a company at Series A, and then exercise a lot of ISOs at Series D, there might be a large amount of this paper income that you receive from the exercise, and if that makes your AMT liability much larger than your normal income tax, you owe the larger AMT amount. 

To use a more concrete example with some slightly fudged numbers for simplicity, let’s say you get a salary of $150K. You take your standard deduction, so you end up with about $138K of taxable income. That will stick you into the 24% tax bracket, and you’ll owe somewhere on the order of $33K in income tax. Let’s say that you have no other income, but you exercise 10,000 options with a strike price of $1 and the 409A valuation at the time of exercise is $5. The IRS sees that you have $40,000 in gains, and AMT uses a flat 26% tax rate and doesn’t allow you to take the standard deduction, and determines that you have $190K in income, and AMT liability of $49K. Well, now your tax bill is going to be $49K for the year. This isn’t entirely the end of the story as, when you pay AMT, you’ll receive AMT credits that can be recouped in years when you have less AMT liability than normal income tax liability. In the example above, you would receive $16K of AMT credits, which are sort of like an interest free loan you’re giving to the government.

However, let’s take a different example. Let’s say you are a much higher earner, and you made $500K in W2 income this year, which puts you closer to the 37% tax rate, and you have income tax liability of $185K. Again, you exercise 10K options, at a $1 strike and a $5 409A. There’s a slightly higher AMT rate of 28% at this level of income, but in total the IRS now looks at your $540K in income, determines that your AMT liability is $151K, which is less than $185K under the traditional income tax system, so you only pay the $151K.

Because of the way this system works, you might have to pay AMT, but you also might not, depending on your overall tax situation. As a result, when you’re making big option exercise decisions, it becomes really important to understand the tax implications, especially if the 409A has been changing. The stuff is hard as hell to understand, so please please please, talk to an accountant about it before you make big decisions.

Again, a change to a company’s 409A valuation won’t cause your strike price to change when exercising your options, but it will change the outlook of your tax liability.

What else could cause the 409A to change?

Under normal circumstances, 409As tend to stay pretty darn stable except when a fundraising round occurs. Fundraises generally cause large step-changes to company valuations, which dramatically impacts the 409A valuation.

Major macroeconomic changes can also dramatically affect 409A valuations. That’s what we’re really seeing right now throughout most of the tech sector. A lot of 409As are being reset in a pretty major way, and we’ve seen some companies, like Instacart, adjusting them again and again, as they prep for their eventual IPO. Because of the rapidly changing macro situation, multiples have contracted, and 409As are dropping significantly. Some of this is precipitated by the macro outlook alone, although some of it is also probably occurring because there are actually fundraising rounds happening, but those fundraising rounds are happening at lower valuations than many companies’ previous valuations.

Secondary sales and tender offers are another way that 409A valuations can be impacted. As I mentioned earlier, a key element to understand about the 409A is that it’s an independently audited valuation of Common stock, not Preferred stock. However, when secondary sales or tender offers (which are really just company-sponsored secondary sales) occur, the transaction is typically between employees selling Common stock to investors at prices closer to Preferred stock prices. This can impact 409A valuations in interesting ways, because if you have a large amount of Common stock being purchased at much higher prices than the current 409A, it would imply that there is a market for Common stock at that higher price. With an isolated secondary sale from a single employee, the company will typically be able to make the case that there’s not actually a market at that price, and it was just an isolated transaction, but with a tender offer, where transaction volumes are typically much higher, it’s harder to make that case. This is a large part of the reason that tender offers are typically restricted to only employees who have a certain amount of tenure, and within that group, they can typically only sell a certain percentage of their stock (say 10% of their vested holdings). Those restrictions allow the company to maintain the argument that the market is not fully liquid at that price, so the 409A should remain lower.

Stock splits or reverse splits are one way that a company can artificially manipulate the 409A valuation. In reality, the value of an outstanding option grant is completely unaffected by splits or reverse splits, nor is the value of the company. The company simply says “for every share you have, we’re going to exchange it for two shares worth half as much,” or in the case of a reverse split, “for every two shares you have, we’ll exchange it for one share worth twice as much.” Splits and reverse splits are typically used as a means to exploit some element of psychology – job offers look sweeter with larger numbers of stock options, even though the value is the same, and public market investors (especially retail investors) will have more appetite for a stock at $20 than a stock at $200, simply because the $200 stock may be perceived to be “more” expensive, despite the company’s enterprise value being exactly the same.

In general, the company’s goal is the keep the 409A low

High 409As are generally not preferable, for hopefully fairly obvious reasons at this point. The higher the 409A, the more expensive it is for employees to exercise options, either because the strike price is high, or the tax liabilities are higher. The closer the 409A valuation is to the preferred price, the less upside there is for prospective employees with offers in hand, which can make it harder to recruit top talent without being forced to give up huge stock awards. However there is only so much control over the 409A that the company has, and the reality is that independent auditors are the ultimate arbiters of stock value.

How should a changing 409A impact your exercise planning?

As with all things tax-related, I strongly encourage talking with a CPA before executing any option exercise. You don’t want to end up in a situation where you don’t know the tax liability before you pull the trigger. That said, so much of answering this question comes down to your knowledge of your own business. Due to contracting multiples, lots of businesses are seeing their 409As reduced meaningfully, and if you think there’s a chance of that (indicators might be that your company isn’t hitting its numbers), there’s probably a good justification to be made to sit tight and wait before doing any exercises. Reduced 409As likely means lower tax liability if you wait to exercise until after the new 409A comes in, and if it pushes your option grant underwater, you probably don’t want to be exercising anything at all.

That said, even in today’s market if you’re receiving new funding, or things are going really well for the business, your 409A could move up. It’s not likely to make major moves up unless there is material information, like a significant fundraising upround, to move the needle. Hopefully that kind of information is shared internally, and if you expect good news on the horizon, it could be a justification for exercising now.

Personally, my default mode of operation is to do any major exercising towards the very end of the year, when I have a full picture of my income and tax liabilities over the course of a year. My wife and I are both heavily commissioned, so our income levels vary from year to year, and that can have a non-trivial impact on how much AMT liability we can absorb before we need to think about setting aside cash for taxes. Waiting till the end of the year gives us the absolute most amount of information to work off of and enables us to partner with our accountant to come up with a strong plan of action. Make good choices!