This comes alongside a new tide of secondary deals; just before you grant employee stock options, we’ve summarized what you need to know about 409A rules: Who is subject to the law? How is the exercise price determined? And what are the key considerations to keep in mind?
Spring has arrived and Passover is just around the corner. However, given the current geopolitical situation, it’s a bit hard to cling to the hope that we are on the brink of moving from the bondage of war to the freedom of the hostages – and to national freedom in general. That said, in the microcosm of the Israeli tech sector, there are signs of a relative recovery that has recently emerged in the volume of fundraising rounds. This follows a year in which the sector underperformed compared to the trend in the U.S., largely due to the ongoing effects of the war. In addition, after a prolonged dry spell, we’ve recently seen signs of renewed secondary deals. It might be due to favourable pricing, or investor expectations for improvement in Israel’s economic outlook in light of the weakening Iranian axis and its proxies – or perhaps a combination – but ultimately, this is good news for Israeli tech. So despite the overall tense atmosphere, we can at least hope this trend continues as we head into the holiday. We wish the Israeli tech sector workforce some peace of mind, self-fulfilment, and of course, successful option exercises. But before you grant your employees options, here’s what you need to know about granting options in accordance with 409A regulations. Who is subject to the law? How is the exercise price determined? And what are the main factors you should consider?
What is 409A, anyway?
American citizens, regardless of where they live in the world, are required to pay taxes on options they receive as soon as they vest, even though in many cases these options expire without ever being exercised. In other words, an employee may have to pay tax on options from which they never earned any income. However, American citizens granted options under the IRS’s 409A rules can defer tax payments until the actual exercise of the options.
Who is subject to the law?
The law applies to anyone who pays tax in the United States: American citizens wherever they are in the world, U.S. residents who file tax returns, green card holders, dual citizens, employees of American subsidiaries, and American citizens living in Israel and working for an Israeli company. Regardless of where the company is incorporated, the relevant question is where the option recipient pays taxes.
Can I claim “I didn’t know”?
An American company that grants options to employees and does not comply with the law’s requirements is exposed to IRS scrutiny. For Israeli companies, ignoring 409A rules exposes employees with American citizenship or residency to significant tax penalties.
How is the exercise price determined?
To comply with U.S. regulations, a valuation of the company’s common stock must be performed. In companies that have recently undergone a fundraising round, the value of the common stock will necessarily be lower than the value of the latest preferred stock. The exercise price must be at least the Fair Market Value (FMV), meaning at least the value of the common stock as determined by a valuation.
How long is a 409A valuation valid?
409A rules allow companies to grant options for up to one year from the valuation date. For example, if a valuation is conducted in December 2024 but values the company as of September 2024, options can be granted based on that share price up to September 2025 at the latest. Why only until then? Because if a significant event occurs at the company before that date, a new valuation must be conducted – even if the year has not yet passed.
What is considered a significant event?
A significant event may include a fundraising round or a secondary transaction, but also a wide variety of occurrences that affect the company’s value, such as a change in the business model. Therefore, if there’s any doubt, it’s advisable to consult with a certified valuation expert on this matter.
Can options be granted today based on a valuation done for a past fundraising round?
A fundraising round from 2022, for example, is not a relevant valuation reference point for 2025. That means, regardless of when the valuation is conducted, the specific date for which the company’s value is assessed (the valuation date) must be close to the transaction date. In the absence of a relevant transaction, the valuation will be based on a DCF or a market multiple approach.
If you have any doubts, we are at your service
S Cube, a member of the IBI Capital Group, is certified by NACVA – the world’s largest valuation association recognized by U.S. authorities. The company specializes in valuing high-tech companies and conducts hundreds of valuations annually for 409A compliance. S Cube was founded in 2005 and has never had a valuation rejected by the IRS. It’s worth noting that meeting the various criteria required by 409A tax regulations involves nuanced issues and raises a variety of questions. So, before you grant options, feel free to consult at no cost with Gidi Shalom Bendor, Founder and CEO of S Cube – email: gidi@s-cube.co.il.
Wishing you a happy and kosher Passover, and above all, we hope this will be a spring of freedom for the hostages and their families.
The content of this article is intended solely for informational and general purposes and should not be considered as factual, complete, or exhaustive information on all aspects mentioned herein. Nothing in the above should be construed as a recommendation to take action. The information does not constitute “investment advice” and/or “investment marketing” as defined in the Regulation of Investment Advice, Investment Marketing, and Portfolio Management Law, 1995, nor does it constitute tax advice tailored to the specific data and needs of any individual, nor a substitute for legal, financial, economic, or professional advice of any kind. S Cube and/or the IBI Group and/or any group company shall not be liable to any person and/or corporation and/or third party for any loss or damage that may result from reliance on or use of the above information.