editione2.1.1Updated September 12, 2022
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.
The 409A valuation of employee equity is usually much less than what investors pay for preferred stock; often, it might be only a third or less of the preferred stock price.
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.
A 409A does have to happen every 12 months to grant the company safe harbor. A 409A also has to be done after any event that could be deemed a “material event,” which is a fancy way of saying any event that could change the price or value of the company meaningfully. Other examples could be if a CEO leaves, if the company starts making a ton of money, or if there is an acquisition.
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.
Typically, early to mid-stage companies grant stock options, which may be ISOs or NSOs.
dangerWhen you get stock options and are considering if and when to exercise, you need to think about the taxes and when you owe them. In principle, you need to think about taxes you may incur at three points in time:
at time of grant
at time of exercise
at time of sale
These events trigger ordinary tax (high), long-term capital gains (lower), or AMT (possibly high) taxes in different ways for NSOs and ISOs.