The 409A Refresh Rule: Set Option Prices Without Employee Penalties

A stale report is the grant-day risk

You are about to grant options, and the report date is the first thing to check. The grant-day mistake is usually an old valuation, not a bad price.

A 409A valuation is an appraisal that sets the fair market value of your common stock. The report covers that stock, supplies the strike price for grants, and usually stays usable for 12 months unless a material event changes value.

Congress added Section 409A in 2004 so option prices would not fall below fair market value on the grant date.

If the IRS concludes options were priced under fair market value and the grant lacked a valid 409A, employees may face regular income tax on the discount, a 20% excise tax, and total penalties that can exceed 45% of the discount.

You need a current report before you offer equity, and you should refresh it annually or sooner if a material change affects business value.

Most founders understand the easy part. They order the report, they get a number, they grant options. The harder part is where the record is incomplete. A report current at the last grant may be stale at the next one, and the next grant tests the file.

The refresh comes before the grant

The sequence matters because the grant sets the price. If the report is old, the price is old too. Keep the grant-day rule: no options before a current 409A, refresh every 12 months or after a material event, use an accredited appraiser for safe-harbor, and document the date and material events.

• Order the appraisal before you announce the grant. The appraisal usually takes two to four weeks, counting from start to final report. You are ready when there is a signed engagement letter and a scheduled delivery date.
• Use an accredited appraiser so the report can carry safe-harbor status, which strengthens your position in an IRS audit. A signed report from that appraiser is the evidence.
• Collect the materials the appraiser will need. The package should include a cap table, recent financials, board materials, and a short list of significant changes since the last report.
• Set the exercise price from the report. The usual failure is signing the grant before the report and treating the valuation as paperwork. The grant agreement should use the report's value as the exercise price.
• Calendar the next refresh. Tie a reminder to the report date and keep a separate note for any significant change.

If the report is late, the grant waits. A delayed grant is easier to explain than a bad grant.

The spread is the employee's cost

For the employee, the exercise price is the entry fee. If it is set too low, the option appears generous on the day it is granted. The tax rules do not reward generosity. They treat a discount as something that should not have been created.

For the founder, the same low price can appear as a small cost. The company does not pay the tax. The employee does. A bad grant can become a trust problem later, when the employee discovers the discount was not free.

A higher price can seem ungenerous. It also keeps the grant defensible. The employee pays more to exercise, but the grant is less likely to create a surprise.

The practical test: ask whether the report supports the price on the day of the grant. If the answer is yes, proceed. If the answer is no, stop the grant and fix the file.

The file carries the audit position

The report alone does not make the file. The file proves that the price was set when it was set.

Put the report, the grant agreement, the board approval, and the event log in a single place. The event log should record the date of the report, the date of the grant, and any significant change that happened between them.

If a significant change happens after the grant, note the change and decide whether a new report is needed before the next grant.

Keep the folder simple.

This article is general information, not investment or legal advice.