Welcome back to Founders University, our core curriculum designed to provide startup founders with the basics needed to launch a company while minimizing costly missteps or mistakes.
For our next session of Founders University, we examine the various traps that threaten founders when granting equity incentives. In this course, partner Lynda Galligan explains what to watch out for and how to avoid common pitfalls.
Ready. Set. Learn!
In granting equity incentives, there are some traps founders should watch out for and avoid.
One such trap appears in Section 409A of the Internal Revenue Code. Section 409A imposes an additional tax – 20%, plus an additional 5% in California – on any arrangements that do not comply with its requirements.
Where 409A applies
A discount stock option can be subject to section 409A. Such an option must have an exercise price of no less than the fair market value on the date of grant in order to be exempt from 409A.
Private companies should obtain third-party valuations at least annually for purposes of setting the correct exercise price for options.
Options can only be granted for plain-vanilla common stock. Options for preferred stock, even if not granted at a discount, are not exempt from 409A. Other incentives such as some types of restricted stock units (RSU), are subject to 409A, and should be structured carefully.
Exempt from 409A
Restricted stock and profits interest are NOT subject to section 409A, so they can sometimes be helpful alternatives.
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