Stock options for startups: 409A valuations, vesting, and the expense nobody books

01The 409A sets the strike price#

An option is the right to buy a share of common stock at a fixed exercise price. Section 409A of the tax code treats an option priced below the stock’s fair market value on the grant date as deferred compensation, with an extra 20% tax and interest for the employee. So the price has to be at least fair market value, and for a private company that means an appraisal.

A 409A valuation is that appraisal. Done by an independent firm and no more than twelve months old, it’s presumed reasonable, and the IRS has to show it was grossly unreasonable to overturn it. Get one before the first grant, refresh it every year and after a priced round or anything else material, and record the price in the board approval for each grant. The appraiser will ask for current financial statements, which is one more reason the books should be closed.

02Vesting and the cliff#

The common schedule is four years with a one-year cliff. Nothing vests for the first twelve months; on the anniversary a quarter vests at once; the rest vests monthly over the next three years. If someone leaves in month eleven, they leave with nothing vested. If they leave in month thirteen, they leave with a quarter of the grant, plus the month just vested, and a window, often 90 days, to exercise it. The 90 days isn’t arbitrary: an incentive stock option exercised more than three months after employment ends is taxed as a non-qualified option.

Founders’ shares usually vest too, as restricted stock rather than options. That’s where the 83(b) election comes in: filed with the IRS within 30 days of the grant, by mail or now online on Form 15620, it taxes the shares at today’s low value instead of at each vesting date. Thirty calendar days, moved to the next business day only when the last one falls on a weekend or holiday, and there is no late fix.

03The expense: ASC 718#

Under US GAAP, stock-based compensation is an expense measured at the grant date and recognized as the award is earned. A private company can use simplifications for some inputs, such as its 409A price as the current share price, but not skip it. A worked example: 48,000 options with a grant-date fair value of $0.40 each are $19,200 of compensation, recognized straight-line at $400 a month for 48 months, starting in the month of grant even though nothing vests until month twelve. The schedule behind it holds:

• Fair value at grant, usually from an option-pricing model with the 409A price as the share price input.
• Recognized over the vesting period, straight-line or by tranche, as compensation in the department the person works in.
• Forfeitures handled by a policy chosen once: as they happen, or estimated up front.
• The grants, the vesting and the expense agreeing with the cap table every month.

04Why it matters at seed#

Stock-based compensation is non-cash, so it doesn’t change burn and it’s added back in the cash flow statement. It still lowers GAAP earnings, and a diligence team that finds two years of grants and no expense will ask for the whole history to be rebuilt. Booking it monthly, from the same cap table that records the grants, costs minutes.