Section 409A of the Internal Revenue Code is where the IRS ruled on deferred compensation plans. This ruling was to prevent a loophole where companies were basically using riskless compensation as at risk compensation. For most small businesses it has no effect, unless the company is issuing stock options in lieu of cash for compensation.

When any company issues stock options in lieu of compensation, it is generally done because the company needs high level talent, but can not afford to pay for it right now. The employees who receive the options do not want to pay taxes on the value of the options until they increase in price, where it then is capital gains, not ordinary income. In order the stock options to be classified as deferred income, and not taxable income, they must pose a significant risk of lost to the employee and be worthless at the time of issuance. The 409A valuation refers to the valuation on the company prior to setting the option price, ensuring the options are 'out of the money' or worthless when they are issued.

Rick Kadet

Vice President, Senior CFO Consultant, The Brenner Group, Inc.

Posted on May 27, 2011

Sorry I missed this question when it first came by. The 409A valuation sets the current value of the common stock of a company that expects to issue stock options. IRS rules require that incentive stock options be issued at fair market value, which in private companies is not so easy to know. Failure to value options correctly can invalidate the favorable tax treatment afforded these options which can cause a lot of problems for the option holder as well as the company issuing the options.

Typically a firm wishing to issue options will engage a professional appraisal firm, but does not have to do this in all instances. But only with a professional independant appraisal can you feel confident that the appraisal has been completed to professional standards and will withstand both external audit for stock option expensing and IRS review as well.

Mr. Green has indicted that the valuation is to determine that the options are worthless. In fact this is not the case. The options will have value and the typical way of finding out the value is to use the Black Scholes model for option pricing. Even well out of the money options will have some value even if nominal. But in a private company such as Facebook, you can be sure that the any option held by an employee is far from worthless.

Many stock options are issued by companies that have venture capital backing or expect to. There may be several classes of shares with institutional investors having preferred class. The 409A valuation is to protect the common option holder from IRS charges that he/she received "cheap stock" and therefore owes tax on the grant.

One final comment; it makes a difference who does the 409A valuation. Seek out firms that do many valuations and have certified financial planners doing the work. Valuations are complex and the larger the value of your company, the more likely the IRS may be to challenge an appraisal that does not come from a known source. I would avoid offshore appraisals where the person doing the work would not be available to defend it.

Dan Walter

President and CEO, Performensation

Posted on July 3, 2011

The following xtranormal video was created by Dave Thomas from Wilson Soncini. 8 mins and 409A makes far more sense. (at least as good as I can do in text here).

http://www.xtranormal.com/watch/11089378/stock-options-409a-compliance

Michael Gilburd

President, ValuCorp

Posted on July 4, 2011

Please note that when you seek out firms that do Valuations find out their track with the IRS, and be sure they are not only US-based, but also that the Valuation Report will be rendered as a “qualified appraiser” as defined under Treasury Regulation 1.170A-13(c)(3), i.e., by a “qualified appraisal firm” and their “qualified appraiser.” There's more info on this topic at www.valucorp.net/valuations/ValuCorp-IntellectualProperty.pdf.