Does a New 409A Valuation Prevent Staff from Exercising Vested Stock Options While It is in Progress?

New 409A valuations do not inherently prevent employees from exercising their vested stock options while the valuation process is ongoing. Employees are generally permitted to exercise their options based on the last completed 409A valuation. This means that a new valuation in progress does not automatically block such exercises.

However, companies may choose to lock out stock option exercises during the valuation period. This precaution is often taken to avoid potential misunderstandings and complications. There are two main reasons for this:

Why Companies Might Temporarily Lock Out Stock Option Exercises

First, if the company uses the old valuation price, they would need to justify to the IRS why employees are treating the fair market value (FMV) of a share as 5 when a pending new valuation indicates an FMV of 8. This justification could be challenging.

Second, if the company uses the new valuation price, it could result in a situation where employees are taxed based on an 8 FMV, even if they believed their options would be exercised at a 5 FMV. This outcome could lead to dissatisfaction among employees.

Companies would most likely impose such a lockout if they anticipate the new 409A valuation being significantly higher than the previous one. For example, if the 409A valuation was 5 and the company just raised funding at 20 per share, the company would not want to argue that the 5 valuation was still fair post-funding round.

Valuation for Tax Purposes: The Most Recent Completed 409A Valuation

For tax purposes, the valuation typically used is the most recent completed 409A valuation prior to the exercise of the options. Therefore, if an employee exercises options during a pending new valuation, the exercise price is based on the last finalized 409A valuation.

Companies are advised to ensure that valuations are updated regularly to maintain compliance and avoid tax issues for their employees. Consulting with a tax professional or legal advisor is recommended for specific concerns.

In practice, old valuations can still be used while new valuations are in process, even if they yield a higher price. However, valuations must reasonably reflect the fair market value. Any dramatic events can cause periods where a 409A valuation cannot be used, necessitating a temporary lockout on exercising options.

Understanding and managing these rules effectively can help companies both protect their financial interests and maintain employee satisfaction. Proper communication and transparent procedures can mitigate potential misunderstandings and ensure compliance with 409A regulations.