Use 409A risk & expense to improve the company

This short summary notes that IRC Section 409Ais now effective (actually as of January 1, 2009). While there are number of well-known types of deferred compensation that are subject to 409A, there is one area where the exact application of the law can be confusing even to those who specialize in general corporate practice.Incentive stock options are not subject to the new law, and this point has been widely reported, since ISOs are an extremely common form of deferred compensation, particularly at companies that do not have more complex plans. However, the exception is almost never reported: if the options do not in fact qualify (i.e., at the time of a later investigation) as ISOs, they are subject to 409A. Since the most likely reason for stock option grants believed to be ISOs to “lose” this status is because they were not granted at the proper fair market value, not only is the status determined ex post facto, but there will be no opportunity to cure the defect at the time of discovery.

As a reality, every private company issuing stock options has to address prospective 409A liability as part of its risk management activities. How do 409A valuations differ from traditional valuations? The statute sets out a number of parameters and procedures, but any quality valuation expert already knows these things. The key issue, where in-house finance and accounting personnel typically have much less experience, is in valuing not only the company as a whole but rather the specific security that is or may be subject to 409A. Private, venture-funded companies in Silicon Valley have issued options to purchase common stock at 10% of the most recent preferred round as a rule of thumb. What 409A tells us is that this “as a matter of course” approach is no longer permitted and subjects companies, and optionholders, to substantial risks.

We have worked hard to integrate the 409A valuation process into corporate governance, budgeting, strategic planning, and finanfcial analysis work that we have been doing for our private and public clients. We can help you use this new legal requirement to actually improve your overall governance and planning initiatives. If you’ve recently done a 409A valuation, bring that to us: we can build on it to help you recapture your expense and turn it into an investment.

Edited 4/2012.

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