Section 409A of the Internal Revenue Code (referred to as 409A) imposes stiff penalties for issuing stock options with an exercise price below the FMV of the shares at the time the option is granted.

The safest way for startups to comply with 409A is to obtain a 409A valuation from a qualified independent appraiser when they are ready to issue stock options. A 409A valuation attempts to determine the FMV of the startup's common stock as of a specific date, known as the valuation date. IRS regulations provide a safe harbor for 409A valuations obtained from qualified independent appraisers - the burden of proof is on the IRS to show that they are grossly unreasonable. Without a 409A valuation, it would be up to the company to prove that the exercise price of a stock option was not grossly unreasonable.

409A valuations from independent appraisers are valid until the earlier of (1) the 1-year anniversary of the valuation date, or (2) the occurrence of an event that would materially change the value of the corporation. After a 409A valuation becomes invalid, the startup will need to obtain a new 409A valuation in order to continue issuing stock options under the 409A safe harbor.

As startups get more mature, they typically have accounting firms perform financial audits. Audit firms often require companies to get prior 409A valuations redone by new appraisers if they have doubts about the quality of the initial valuations. Thus, when selecting an independent appraiser for a 409A valuation, you should try to get a sense for how their valuations have held up under scrutiny by audit firms.

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