All the startups granting options need to get a 409A valuation done, thru third parties to establish the common stock price of your company. As a rule, the options can be granted with a strike price equal to or greater than the value of the stock established in 409A report ( A Fair Market Value – FMV). Therefore, all Startups must perform the business valuation before they grant the options to justify the exercising price they set. The risk of non-compliance with the IRC 409A is severe. If this code is violated, the option holders must pay the taxes on vested shares, 20% penalty tax, and interest on unpaid taxes. This means reputation of your startup could be at stake.
Who does give you 409A report?
There are a lot of firms that specialize in this area and they can give you one for a price in the upward of $2000. When a startup is really starting up and has nothing in place except the sweat of the promoters, does it really spend that kind of amount for getting a valuation report, for granting the options? No. In the following circumstances, the founders can generate their own 409A valuation report:
a) your company has not raised more than 500K,
b) never issued SAFE, or convertible Debt instruments,
c) no consistent revenue,
d) no IPO/acquisition happens in next 180/90 days respectively, or
e) has no assets more than $100K
The IRS doesn’t want you to grant the options the FMV( Fair Market Value), because of the tax implications of the options. Both Incentive Stock Options (ISO) and Non-Qualified Stock Options (NQSO) shall be issued based on FMV, and if the FMV is not set up while granting the ISOs, the ISO’s treated as NQSO and fall under 409A jurisdiction!
So Set up a Stock option plan very early, to avoid expensive and avoidable Valuations!