It is very common for start-up companies to issue stock options to certain key employees, but there are significant risks in doing so to both the option recipient and the company under Internal Revenue Code (IRC) Section 409A if the options have an exercise price less than the fair market value of the common stock as of the option grant date. Internal Revenue Service (IRS) regulations require that fair market value be determined using "reasonable application of a reasonable valuation method," and provide a presumption that a company's fair market value determination will be considered reasonable if it takes into account the relevant valuation factors described in the regulations, and:
(a) if the valuation is determined by an independent appraisal no more than 12 months before the transaction date; OR
(b) if the valuation is of "illiquid stock of a start-up corporation" and is made reasonably, in good faith, evidenced by a written report, performed by a person with significant knowledge and experience or training in performing such valuations
But the costs of obtaining an independent appraisal may be high for start-up companies, and the company may not have ready access to a person who has "significant knowledge and experience or training in performing such valuations."
WHAT YOU SHOULD DO
If a start-up company is considering issuing stock options, it is important to understand the requirements of IRC 409A as early as possible in the process, and to plan for the costs of obtaining the required valuation. In such cases, a start-up company may find that it will be better served by issuing restricted stock or some other equity vehicle which falls outside the purview of IRC 409A, instead of stock options.