Having, perhaps, read my last post about performing regular common stock valuations for 409 and 123 purposes, one logical question that you might ask is "Why does 409 even matter?" Or more simply, "Why should I care?"
When you hire a key employee and offer her stock options, this is generally not a taxable event for a variety of practical and legal reasons. One of the keys to protecting this tax free grant of value--and it is valuable--is to establish that the strike price of the option is not lower than the fair market value of the common stock.
For instance, if you were granted stock options in a public company with a strike price (the price you are required to pay for the stock when you exercise the option) of $50 when the stock price is $100, you can see that these options would be worth money right out of the shoot. In contrast, if the stock price were just $50, there is no intrinsic value in the option. If you exercise the option and pay your $50, when you sell the stock you receive $50 and you've made no money.
Without wishing to suggest that this is the only consideration, the IRS will generally consider an option with a strike price equal to or less greater than the value of the common stock to require no tax obligation at the time the option is granted. In the alternative, the IRS will seek to tax the embedded gain bestowed at the time of the initial grant. If this is caught years later, penalties and interest may apply.
This results in making your key employees unhappy and disillusioned instead of happy and motivated.
In private companies that don't have a trading stock that would establish the value of the stock, the IRS has suggested that the best way to determine the value of the common stock would be to hire a professional valuation firm or other expert firm to provide an independent assessment.
Note: Update thanks to Brook!
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