Valid 409A Needed to Exercise?

Have you noticed that Carta won’t let your optionholders exercise unless you have a current tax code Section 409A valuation (which Carta allows to be board determined as a stop gap if the company is in the process of a financing or some other material event which would delay a full independent valuation).  I was recently asked what I thought about this.

My thoughts:

1. A Section 409A valuation provides a safe harbor for the lesser of 12 months or until a material event occurs (the “safe harbor period”) only for the setting of the exercise price for stock options.
2. Technically this means that every time an option is exercised in a private company the board needs to determine the fair market value on that day for purposes of tax reporting and possible withholding and that value should, all things considered, not stay in a straight line a year at a time.
3. It is wildly market practice however to rely on a Section 409A valuation for the “safe harbor period” for the tax reporting of options on exercise.  Basically everyone does this (including Carta) and it’s probably a fairly safe practice because “everyone’s doing it” and the alternative is so impractical.
4. Under every stock option plan I’ve ever seen, a company does not have the right to prohibit exercise just because it does not have a current Section 409A valuation.  So, companies that use Carta should realize they are in breach of contract if someone tries to validly exercise and cannot.
5. Do you actually need to know the value on the date of exercise? For NSOs exercised by employees one needs to know the fair market value on the exercise date because withholding is required which means the employee needs to write a check for the exercise price and the tax withholding. For ISOs, or for NSOs exercised by advisors, one could theoretically rely on new 409A data for tax reporting purposes.

For example, for the folks exercising ISOs during the period between term sheet signing and company’s determination of the post-financing FMV, we’d suggest that the company let such exercising ISO holder know that:

1. The company is required to report the spread at exercise on a Form 3921 to the optionee by Jan 31 of next year, the IRS gets a copy, and such spread may cause alternative minimum tax (AMT).
2. The company is unsure of what value it will use to calculate that spread at this moment and will take into account the post-financing 409A in making that determination.
3. No one at the company is authorized to give the optionee tax advice and it is recommended that the optionee speak with its own tax advisors before exercising.

Mike Baker frequently advises with respect to stock options. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.