“It's a secret, but no secret
It's a rule, but no rule”
“Cooksferry Queen” by Richard Thompson
It feels like once or twice a day I speak with a startup that has tripped over a seemingly invisible rule applicable to founder equity: the founders and early employees/advisors in startups really need to get their stock or options BEFORE there’s a term sheet for a venture or angel funding. While not a secret, the law doesn’t come right out and expressly say this. Frankly, to know this you’d have to talk to folks who have an understanding of tax law, corporate law and startup life. That understanding, unfortunately, is in shorter supply than it should be and, for founders, seems to largely have been learned the Sharon Jones & the Dap Kings way:
“I learned the hard way, baby. Now I know about you. I learned the hard way … Not to be your fool.” I wonder whether Sharon was singing about Section 409A?
In an effort to save folks both cash and heartache, and to save other folks (especially me) the time involved in having to explain this (I currently explain this to founders multiple times each week), I’ve laid out below some background on the rule, an explanation of how and why founders most commonly miss this, and finally, how to avoid learning it the hard way (thanks Sharon…love your tunes!). Let’s start by explaining the problems pertaining to stock options and then discuss founder stock.
Background on Section 409A
In 2004, the IRS announced that it was going to change the way stock options worked for startups. Okay, it didn’t actually say “for startups,” but that’s our focus in reviewing Section 409A of the Internal Revenue Code, a rule which phased in over the following few years and was a backlash against the abuses of Enron, Worldcom and the executives who took cash off the table ahead of investors who were left with worthless Enron and Worldcom stock.
Why 409A Matters for Startups
The rule applies to deferred compensation. Have your eyes already glazed over? Mine have! But stay with me because we’re talking about stock options, the key currency for startup talent recruiting and retention. The rule, in oversimplified and practical terms, says that you can’t grant stock options at an exercise price below the then-current fair market value of the stock you’d get for exercising that option.
So how does this translate into giving stock before your startup gets a term sheet? Glad you asked!
The IRS gave guidance urging startups to obtain an independent written valuation using accepted methodology done by someone skilled in the field of valuing companies. This spawned a cottage industry of 409A valuation firms. Here’s where it gets complicated. The IRS wanted to help all of us by offering some degree of clarity and ‘protection,’ which I’d describe as complex and a bit fuzzy. The ‘protection’ in this instance, means that if you do what the IRS prescribes, the IRS will give you the benefit of a “rebuttable presumption” that you didn’t screw things up. A “rebuttable presumption” is NOT a “safe harbor;” rather it’s just a presumption that the IRS can overcome by showing that the valuation method or its application was “grossly unreasonable,” whatever that means. We have to take what we can get because the presumption is all the IRS was willing to give us!
While the IRS also allows a rebuttable presumption for valuations performed by someone affiliated with the startup, it also suggests that the affiliated valuation person should have logged at least five years of valuation-focused experience (business valuation, accounting, investment banking, private equity), but even then, a “good faith” effort isn’t sufficient, so we’re not surprised that most startups we see do use an independent valuation firm.
Oh Joy, a Rebuttable Presumption! Gee Thanks!
Here’s how you typically can avail yourself of Section 409A’s rebuttable presumption: The startup’s board of directors has to review the valuation report and it really should deliberate about it (does the report make sense, are the facts correct, does it definitely mention the recent transactions in the company’s stock, is the number of shares outstanding correct, are there other errors in it?). Once the board is comfortable with the report’s factual and mathematical accuracy, the board must ask some additional questions. First, the board must ask whether the valuation report is fresh? There are two dates on these 409A valuation reports, the “as of” date (typically the end of a period, like 12/31 or a month end, because valuation firms likes to rely on financial statements dated at the as of date). The second date is the issue date of the report (when the valuation firm completes the work). These reports become stale after a year and sometimes a report can go stale even sooner (growth companies generally get new valuations more than just annually). Specifically, the presumption applies to an independent appraisal that meets the necessary requirements “as of a date that is no more than 12 months before the relevant transaction to which the valuation is applied (for example, the date of grant of a stock option).” If it goes stale, the board can’t rely on it so, paraphrasing Seinfeld’s Soup man, “no presumption for you!”
Next, the board has to consider whether there’s been what I will call a “supervening valuation event,” since a report can go stale if it “fails to reflect information available after the date of the valuation that may materially affect the value of the corporation.” What does that mean, and how does it affect the presumption? Nobody’s entirely sure, but the startup and venture community has reached consensus that one thing that generally qualifies as a “supervening valuation event” is a written term sheet to fund or acquire the company from a realistic purchaser who has actually done some diligence on the startup before issuing the term sheet. So if you get a term sheet that’s for real (we can discuss when a term sheet isn’t for real!), that probably makes the valuation stale, especially if the startup later completes that deal. How much diligence? What’s a realistic purchaser? How much money has to be involved? What if you think the term sheet is entirely inaccurate? The answers to these questions will require some fact-sensitive judgment.
Having gotten some comfort that the report seems accurate and isn’t stale, the board next adopts board resolutions finding that the report’s valuation of a single share of the startup’s common stock accurately reflects the current fair market value of that share. In that same meeting, the board then grants options on common stock with an exercise price per share of not less than the valuation price. Of course, stock option grants are only valid if they contain the number of shares, the strike (or exercise) price per share, the vesting schedule, and the recipient. So all of that should be laid out in the resolutions too. We almost always see that in an exhibit or schedule to the resolutions.
Supervening Valuation Events Also Affect Outright Equity Grants
Section 409A doesn’t specifically apply to giving someone stock, whether outright or subject to risk of forfeiture (vesting). However, and we think this is a pretty big “however”, it would be pretty awkward to grant stock options based on a fresh 409A valuation report that the board has adopted and then give someone shares of stock at a much lower valuation at about the same time. That would mean that the board, acting on behalf of the company, would be taking inconsistent tax positions regarding value of a single share of the company’s common stock. Let’s avoid doing that! I know that “consistency is the hobgoblin of little minds” but this is the IRS we’re talking about! (To the IRS team members reading this: I meant that lovingly, seriously, no disrespect intended!). Also, I’m pretty sure that the Ralph Waldo Emerson “hobgoblins” quote speaks about “foolish consistencies” and to me, it doesn’t seem foolish to say that if a single share of common stock in a privately held startup was worth one thing on Tuesday then absent a “supervening valuation event” it should be worth the same thing on Thursday (see IRS, I really am on your side on this one!).
Founder Stock
So why does this mean founders must receive their stock before the term sheet hits? Well, I needed to build some foundation because this stuff is complex. Let’s say you incorporate the startup on December 2 (most venture capital-backed startups are Delaware C corporations) and there are three founders who toil tirelessly for four months. On April 2, they receive a term sheet stating that a good venture fund will lead a seed round totaling $1 million in a deal that values the startup at $5 million on a pre-money basis. Pre-money valuation simply means that the deal values all the outstanding stock before the investment at $5 million and, when you include the shares the startup will issue for the fund’s $1 million, the startup would be valued at $6 million on a “post-money” basis.
If the founders had documented the issuance of the shares on (or just after) December 2, using a valuation much lower than the April 2 valuation, all is probably well. The IRS is likely to respect the startup’s position that the founders’ hard work has enabled the startup’s value to climb appreciably over the span of four months. But what if the founders had neglected to paper the stock issuance and now have to do that before the deal closes? The IRS might conclude that the reason each founder is receiving her shares is because she either paid for them or worked for them. In most cases, the founders have paid very little cash for their shares and, instead, have mostly worked to earn those shares (equity paid for with hard work rather than cash is often called sweat equity).
Tax on Sweat Equity
How does the IRS treat payment (whether in shares, cash or chocolate) made for a person’s work effort? Well, the IRS treats that as ordinary income and taxes the employee based on when she receives payment (in this case, in shares). Remember that pre-money value of $5 million? The investors are buying preferred stock so their shares are probably worth more than the common shares, but in this case, the common shares are still worth a ton of money. Might those shares of common be worth well over $1 million? Indeed they may well be. Let’s assume – just for our hypothetical – that the common shares held by the founders are worth, in aggregate, $1 million and let’s split that evenly in three ways among all the founders. Now let’s say each founder has used her own cash to fund the company but that in aggregate only totals $10,000. The IRS could conclude that each founder paid $3,333 in cash and is getting roughly $333,333 worth of stock so she has $330,000 of income, and the startup has to withhold income and payroll taxes. In this situation, the founder will be looking at a tax hit of roughly $130,000 (it could be more but that assumes a 40% tax rate on a state and federal level). Had the founders only papered the stock issuance at the beginning (when they incorporated), they likely would not have ANY tax hit at the time of the term sheet.
Promised Equity
Of course, in the situations we typically confront, the founders have also promised equity to at least one employee and one contractor/advisor. (I’ve separately written about the business rationale for stock option vesting for employees and advisors). Those people could have obtained really inexpensive stock options that would now be pretty valuable. But in our hypothetical, the founders haven’t had their lawyer “write anything up” yet because they only called or hired a lawyer when the term sheet arrived. They’re now likely in a “blackout” period for option grants. In other words, it’s too risky to grant options at a low valuation now, because the fair market value of a single share of the startup’s common stock is about to change…dramatically. The startup is right in the middle of a “supervening valuation event” and will likely want to wait until the deal is closed to obtain a valuation report that comports with Section 409A and then issue options at the strike price derived by referencing that report.
The founders would have been better off papering their equity back in December when they formed the corporation and the employee and contractor would have been smart to have insisted on getting their options papered when they started providing services to the startup, rather than waiting for a few months. It’s totally fine for the startup to ask the contractor and employee to wait for the next regularly scheduled board meeting, but the founders shouldn’t be surprised if the employee and contractor express some unhappiness if the price has increased materially because the next board meeting occurs months later.
Fixing a Hole
There may be some ways out of this hole, depending on the facts of your specific situation but the best way out of the hole is to do the paperwork in real time as the situation is unfolding. Otherwise, you’re right back in Sharon Jones’ school where founders learn things the hard way!
