In 1776, in the middle of a hot summer, 56 visionaries met in Philadelphia to write the Declaration of Independence. It was 242 years ago so our perspective may be blurry but it’s safe to say that in 1776, it was an absurdly risky startup.
We all know the opening lines – but do you know how it ends? The last line goes: “we mutually pledge to each other our Lives, our Fortunes, and our sacred Honor“. When you’re involved with startups, it sure feels like that, doesn’t it?
In 2018, forming a company, writing a business plan, getting financed is no mean feat – but at least there are no redcoats or gallows. The FFs did have one challenge in common with today’s entrepreneurs – finding and retaining the personnel to make the vision a reality and figuring out how to actually pay them and get them to stay.
Today’s entrepreneurs entice key employees with the promise of deferred compensation, generally in the form of options, warrants and other interesting financial instruments. But unlike the “summer soldier” and the “sunshine patriot”, today’s best recruits know their way around a cap table. They know that upon receiving a boatload of options, those options need to be properly valued and that valuation (at Fair Market Value per IRC Sec 409A) needs to pass muster with the IRS and if it doesn’t there could be severe tax penalties heaped upon the head of the EMPLOYEE. We’re talking immediate taxation plus a 20% penalty– talk about pledging one’s fortune. It’s not unusual for savvy and talented would-be employees to ask questions about the 409A valuation before signing on to march with the rest of the gang in the garage, or wherever.
The bottom line is this: a 409A valuation gives the company and the employees some comfort and guidance on deferred compensation, but ONLY if done right. Generally, very few people see, read or even care about the valuation report (even fewer understand it). The people who DO care about every little piece of it is the IRS and if the IRS is asking to see it, it had better be done according to the IRS’s requirements. It’s kind of like insurance, the only time you really think about it is when you really NEED it. If it’s not done properly, the employee could well be on the hook for serious pain! King George has nothing on these folks.
So I think we can agree that when it comes to 409A, it’s far better to do the work and get it right the first time than to have to deal with the consequences later. As our top recruiter, Ben Franklin (he recruited France) said, “We must, indeed, all hang together, or most assuredly we shall all hang separately.”
Stay tuned for Part 2.