Section 409A
IRS code governing deferred compensation; requires options be priced at fair market value.
Definition
Section 409A of the Internal Revenue Code governs nonqualified deferred compensation. For startup employees, its most important effect is requiring that stock options be granted at or above fair market value (as determined by a 409A valuation). If options are granted below FMV (discounted options), the holder faces a 20% penalty tax plus interest on the deferred amount. This is why every startup gets periodic 409A valuations.
Why it matters
409A compliance protects you from penalty taxes. If a company grants you options without a valid 409A valuation, you could face significant tax penalties. Reputable companies always maintain current 409A valuations.
Example
A company's 409A valuation is $3/share. All options granted must have at least a $3 strike price. If the company granted options at $1/share without a valid 409A, every option holder could face a 20% penalty tax on the deferred compensation.