Consequences of backdating stock options

Next, it describes the valuation rules that were established by the Section 409A guidance issued by the IRS, including the Safe Harbors.It then describes the reactions of privately held companies of varying sizes and stages of maturity we have observed — what managements, their boards and their advisors are actually doing on the ground.

There are a number of significant issues relating to the effect of Section 409A on option terms and on nonqualified deferred compensation more generally that are beyond the scope of this article.The trial court granted the defendants summary judgment, holding that FH Partners didn’t own the loan and so it couldn’t enforce it.On appeal, the Missouri Court of Appeals, Western District agreed.(Jason Mark Anderman illustrates the logistics problem well in this comment to a backdating post on Ken Adams’s blog.) There’s nothing inherently illegal or unethical about backdating contracts, although backdating can certainly be both unethical and illegal, depending on the situation.For those with an hour to kill thinking about the issues, Jeffrey Kwall and Stuart Duhl wrote an excellent article on backdating that was published in Business Lawyer in 2008.Under Section 409A, unless certain requirements are satisfied, amounts deferred under a nonqualified deferred compensation plan (as defined in the regulations) currently are includible in gross income unless such amounts are subject to a substantial risk of forfeiture.In addition, such deferred amounts are subject to an additional 20 percent federal income tax, interest, and penalties.In contrast to past practice, the Section 409A regulations (the final version of which was issued by the IRS in 2007) contained detailed guidelines for determining the fair market value of the common stock of a privately held company by requiring a “reasonable application of a reasonable valuation method”, including a few presumptively reasonable valuation methods or "Safe Harbors." These rules have reshaped private company common stock valuation and option pricing practices.This article first briefly describes pre-Section 409A common stock valuation practices — the time-honored appropriate discount method.It was the longstanding practice of privately held companies and their legal and accounting advisors to determine the fair market value of their common stock for purposes of setting option exercise prices by loosely estimating an appropriate discount from the price of recently issued preferred stock on the basis of the company's stage of development.This practice, previously accepted by the Internal Revenue Service (the “IRS” or the “Service”) and the Securities and Exchange Commission (the "SEC"), was abruptly ended by the initial Internal Revenue Code Section 409A guidance issued by the IRS in 2005.