When a person’s stock vests, or they exercise an option, the IRS determines the tax that person owes. But if no one is buying and selling stock, as is the case in most startups, then the value of the stock—and thus any tax owed on it—is not obvious.
Definition The fair market value (FMV) of any good or property refers to a price upon which the buyer and seller have agreed, when both parties are willing, knowledgeable, and not under direct pressure to carry out the exchange. The fair market value of a company’s stock refers to the price at which a company will issue stock to its employees, and is used by the IRS to calculate how much tax an employee owes on any equity compensation they receive. The FMV of a company’s stock is determined by the company’s most recent 409A valuation.
Definition A 409A valuation is an assessment private companies are required by the IRS to conduct regarding the value of any equity the company issues or offers to employees. A company wants the 409A to be low, so that employees make more off options, but not so low the IRS won’t consider it reasonable. In order to minimize the risk that a 409A valuation is manipulated to the benefit of the company, companies hire independent firms to perform 409A valuations, typically annually or after events like fundraising.
🌪controversy Although the 409A process is required and completely standard for startups, the practice is a strange mix of formality and complete guesswork. It has been called “quite precise—remarkably inaccurate,” by venture capitalist Bill Gurley. You can read more about its nuances and controversies.
🚧incomplete More on when 409As happen.
∑technical “FMV” is a legal term defined in Supreme Court Case 546, United States vs. Cartwright.
∑technical “409A” is a reference to the section of the Internal Revenue Code that sets requirements for options to be tax-free on grant.
Stock options, RSUs, job offers, and taxes—a detailed reference, including hundreds of resources, explained from the ground up and made to be improved over time.