As per section 409A, companies have to grant their common stock at or above the fair market value of the shares.
In 2007, section 409A was added to the IRC (Internal Revenue Code), due in part to the Enron scandal. It is a method to keep any executive from taking advantage of loopholes found in equity compensation plans. As per section 409A, companies have to grant their common stock at or above the fair market value of the shares.
The FMV of the company shares is figured out from the 409A valuation conducted by a third party professional. In case the company does not have the 409A valuation done by a third party firm or professional and issue the shares, the IRS can come unannounced and conduct a review.
If the strike price of shares issued are not at least at the fair market value of the common stock, the IRS may impose penalties for the company to pay immediately. If found in non-compliance with section 409a, they as well as the company’s shareholders would have to pay the 409A penalty fees.
As per the IRS, a company about to issue the grants can have their 409A valuation done and maintain a safe harbor status. This safe harbour status requires the IRS, not the company, to prove that the 409A valuation of the company shares is not justified. Therefore, it is important to note that the 409A valuations usually should not be done by a person inside the company. It has to be conducted by a third party. In general, this is the more accepted as the 409A valuation.
If you are still not sure about what 409A valuations are, check out our blog on 409A valuations and all you need to know about them. Contact Eqvista today, and we can assist you in understanding it better. Also, if you are not yet using a cap table for keeping track of all the shares in your company, then you should sign up for our Eqvista software.