Option pools and 409A: why the strike price must be fair market value

The fair market value rule

Treasury regulations under section 409A say a stock option generally does not provide deferred compensation if the exercise price can never be less than the fair market value of the underlying stock on the grant date, among other conditions. If an option does fall under 409A and fails its requirements, the statute provides for income inclusion, interest, and an additional tax equal to 20 percent of the amount included.

Incentive stock options have their own rules. Section 422 requires an option price not less than the fair market value at grant and a term of no more than 10 years. To the extent options first exercisable by an employee in a calendar year cover stock worth more than $100,000, measured at grant, the excess is treated as nonqualified options.

Supporting the valuation

The regulations give presumptions of reasonableness. One covers a valuation by an independent appraisal as of a date no more than 12 months before the grant. Another covers illiquid stock of a start-up corporation, generally one without a material trade or business conducted for 10 years or more, when the valuation is made reasonably and in good faith by a qualified person, among other conditions.

Example: A board adopted an independent valuation in January and wants to grant options in October. The 12-month window has not passed, but the company closed a SAFE round in July. The regulations say a previously calculated value is not reasonable if it fails to reflect later information that may materially affect value. The board should consider whether a new valuation is needed before granting.

Sizing and approving the pool

Under Delaware law, a corporation may issue rights or options to acquire its stock, and the board sets the terms. Size the pool against a hiring plan and show it on a fully diluted cap table. Investors in a priced round often require the pool to be set or increased before their investment, which places that dilution on existing holders.

Option grants are securities issuances. Federally, many private companies rely on Rule 701, which limits sales in a 12-month period to the greatest of $1,000,000, 15 percent of total assets or 15 percent of the outstanding class, and requires more disclosure above $10 million in 12 months. In California, the DFPI says a notice under Corporations Code section 25102(o) is due no more than 30 days after the initial issuance under the plan.

Your next steps

1. Grant options at no less than fair market value on the grant date.
2. Refresh the valuation after material events, not only every 12 months.
3. Approve grants at board level and make the federal and California securities filings.