Companies are required by the IRS (Section 409A) to show that their common stock options are issued at fair market value, and therefore must conduct a formal valuation opinion at least once every 12 months to avoid potential tax penalties. They also must use the fair-value method of accounting for stock-based compensation such as stock options to comply with the Financial Accounting Standards Board rules (ASC 505 and 718). Determining the fair market value of a closely held entity is a difficult task requiring the consideration of numerous factors, and the implementation of various computational tools.

Founders and management should familiarize themselves with 409A valuations early in the company’s life. Section 409A of the Internal Revenue Code will come into play once you start to think about hiring. Internal Revenue Code section 409A applies to stock options and stock appreciation rights (SARs) defined as deferred compensation.

Under section 409A, stock options that have an exercise price less than the Fair Market Value (FMV) of the underlying stock as of the grant date could result in adverse tax consequences for the option recipient. Depending on the severity of the issue, there may be substantial tax consequences, including consequences for the individual taxpayer. Non-compliance carries a hefty price tag in that it renders any deferments under the affected compensation plan taxable for the current year and potentially all prior years.