So you're pre-409A with a side of advisor compensation...
What does the funky IRS rule have to do with advisor comp?
Hey founders et al. In today’s edition, we explore why a 409A isn’t totally necessary for advisor compensation in the wee days of your company. We also highlight great attorneys and tools as you navigate equity compensation.
Don’t forget about the Legal Toolbox for Founders database. And to join our unmatched and unforgettable referral program, scroll to the bottom.
Advisor Compensation pre-409A
A question that pops up a bunch with early stage founders is how to compensate advisors (and possibly early employees) before a 409A valuation has been completed. It’s a weird stage for a company because you and your co-founders may be your only employees and you’ve yet to go through any financing round at a formal valuation. Prior to establishing a fair market value (FMV) through a 409A valuation, you can still compensate an advisor with equity via a stock grant or restricted stock grant. In that case, it is either taxable at its FMV when it vests under 83(a) or, in the event of an 83(b) election, it is taxed at its FMV at the time the election is made.
Why is a 409A not needed when granting stock vs options? A FMV for your company is a requirement to issuing stock options to employees and advisors. “409A” actually stands for the IRS Rule that provides a safe harbor for companies that undergo an independent third party audit in order to set their FMV for deferred compensation purposes. The 409A valuation is simply how companies set their FMV for the issuance of deferred compensation (in this case, options). The same statutory safe harbor does not exist for the issuance of stock or restricted stock. This means that you can compensate an advisor with equity even if you do not have one of the statutory valuation methodologies (the 409A) in place.
One thing to keep in mind: you still need to assign a FMV and properly value your stock. You just don’t need to do so through a 409A process. In the event of an IRS audit, you will bear the burden of showing that the reported FMV was in fact the FMV at the time of the grant. Generally this can be done by granting stock based on the valuation of a recent financing event, as that helps establish the FMV. If you are very early stage (pre-product, pre-assets, pre-funding), you could issue advisor stock at par value... but again, you’ll have audit risk on the board's determination of fair market value.
If all of this is gibberish to you, great! That’s what we’re here for. Check out the tools below for more reading, resources and lawyers who can help you navigate this crazy statutory soup.
Tools and Resources
There are some excellent advisor compensation resources out there that founders may not know about. We are always adding to this list. See the full list of resources here.
What the heck is a 409A valuation anyway? The internet is both great and also full of SEO content vomit. Sometimes it’s hard to find quality. Here are some of the better writings on 409As and advisor compensation options from A16Z, TheTaxAdvisor, and good ol’ wikipedia... don’t sleep on the Wiki for unbiased and incentive-free content.
Need a simple template for advisor agreements? The FAST agreement from the Founder Institute is a reliable standard and simplifies the advisor relationship and compensation structure. It can be used to grant options and equity, and is designed to be flexible based on stage of startup and jurisdiction. Read the information on their site and feel free to ask your attorney about this doc when considering easy plug-n-play options.
New-school thinking: Cabal is creating a cool future for startup advisor compensation and incentive structuring, where advisor compensation is more closely linked to actual contribution. Check out their take on what a modern advisor program could look like. I’d like to do a longer piece on this shortly, so stay tuned!
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Lawyers
We love highlighting founder-friendly lawyers doing great work in startup spaces. Check out our database of founder-friendly firms and lawyers for previously highlighted lawyers.
“Matt and the entire Catalyst Law team is a fantastic resource for any startup. He is knowledgeable and professional and ensures that everything in the deal sets the company up for future success.”
Matt Hyde and the entire Catalyst Law team comes highly recommended from a founder in the On Deck ecosystem working on a stealth startup. Catalyst Law helps early stage and growth companies in a long list of areas that include financing, mergers and acquisitions, entity formation and startup strategy. Matt helped this founder and his company with their fundraising legal needs, and they returned the favor by telling us about their positive experience! Thanks Matt and the entire Catalyst team for being founder friendly.
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Brian