Startup Equity #2: Why Startups Purposefully Undervalue Themselves to IRS Auditors Every Year
Hello again, and welcome back to our deep dive into the complex world of startup equity. In today’s post, we’re exploring a particularly intriguing aspect of startup finances: the strategic undervaluation in the eyes of IRS auditors, and how this affects your Incentive Stock Options (ISOs).
In case you missed the previous article, here is a link to refresh yourself on the basics of startup compensation:
Decoding the Valuation Game
When startups go through the process of a 409A valuation to determine the Fair Market Value (FMV) of their stock, they are performing a fine balancing act between trying to convince the auditor to give them a lower valuation while also trying not to commit securities fraud. This valuation directly impacts how much you, as an employee, will pay to exercise your ISOs.
Understanding ISOs and AMT
Let’s revisit my initial offer out of college in San Francisco for some context: $120k in cash + 10,000 ISOs + benefits. The ISOs come with a vesting schedule, but they also come with a tax caveat called the Alternative Minimum Tax (AMT).
The AMT is designed to ensure that taxpayers with substantial deductions or exclusions pay at least a minimum amount of tax. If you exercise your ISOs and hold onto the shares, the difference between the strike price and the FMV at the time of exercise is considered a “preference item” for AMT purposes. This can significantly increase your tax bill, even if you don’t sell the shares and thus don’t have the actual, liquid cash from the gain.
Example of Valuation Impact
Using my example from my previous post:
- Strike Price: The FMV at the time of my hiring, set by the 409A valuation, was $1.15 per share.
- Preferred Share Price: At the time of the last funding round, the preferred share price might have been $7.50.
The spread between these prices ($6.35 per share) is the amount considered for AMT purposes if I decide to exercise my options and hold the shares. This shows a clear incentive to get as low of a FMV as possible.
AMT Calculation
One of the benefits of being given the ability to early exercise your stock is that you can buy all 4 years of ISOs up front, and with that, your strike price will be equal to the FMV at the time. So in my example if I early exercised shortly after joining. I would file an 83B election with the IRS that tells them I exercised my options at $1.15 per share. So I spend $1.15 * 10,000 = $11,500 to exercise everything.
Given that the FMV will not have changed as I have just joined the company my total amount that would be subject to AMT tax is 10,000 * (1.15 (FMV) — 1.15 (strike)) = $0.
Now let’s run through a different scenario, lets say I have been with the company for 2 years and have money saved up that I would like to use to convert my ISOs to common stock. Let’s say the company has grown and we now have a preferred share price of $20, giving me a total equity grant of $200,000 at current company valuation. Our new 409A is much higher because of how well the company has performed, so even with incredible negotiations with our auditor, the lowest they would be willing to defend in court was $5 a share.
This all sounds great, the company has grown in valuation tremendously and my initial grant is worth over 2.5x as much as when I joined! This is where AMT tax will come and try to ruin your day. Exercising my whole grant will still cost me the same: $1.15 * 10,000 = $11,500 since our strike price was fixed when we joined the company. Calculating the amount considered for AMT is 10,000 * (5–1.15) = $38,500.
So what does this mean? Is that what I pay the IRS? Calculating AMT can be a bit complicated, so I used an online calculator:
This shows that I would owe the IRS an extra $6,600 in income taxes if I still made $120k, not horrible in the grand scheme of things, but it is something that would be surprising if you didn’t expect it. This also can go up a lot based on your income. If I put my income as $250k, I would owe close to $14,000 — more than the price to exercise my options in the first place.
Golden Handcuffs
Everyone in Silicon Valley has met employees who might want to leave their company but can’t justify it because of how much their stock has appreciated. Most recently this has been happening at places like Nvidia and Facebook. There are much worse equivalents for early startup employees. Aside from their stock having a much greater upside resulting in a similar issue to big tech employees with RSUs, employees might be stuck with huge AMT tax bills.
I have had friends at other startups who went public resulting in them owing $500,000 AMT tax bills that they can’t afford to pay to exercise their ISOs. This becomes especially bad because they cannot afford to quit their jobs without losing everything, literally.
ISO Expirations
If say after 4 years at my existing company I decide it is time to move on and I for some reason have not gotten any other equity grants, (huge red flag on the company’s behalf) I would have to make sure to exercise all my vested ISOs otherwise they will expire worthless after 90 days.
Here is a chart from Carta showing what percentage of ISOs have greater than a 90-day expiration policy. This means that for the vast majority of startup employees, once they quit their jobs, they have 90 days to exercise everything they have vested, otherwise their options will expire worthless. This is why it’s so important for employees to early exercise if given the choice and why startups will try to get low 409A valuations.
The Risk of Undervaluation
Given how many problems can arise due to skyrocketing startup valuations, it is a small wonder that companies don’t go to greater lengths to lower their valuations to auditors. However, undervaluing can lead to complications:
- IRS Audits: If the IRS believes the 409A valuation was too low, it can lead to audits and penalties. Inside a 409A report, there is a section about comparable companies and their valuations which provides a baseline for the IRS to use.
- Investor Perception: Extreme undervaluations might raise eyebrows among potential investors or acquirers, affecting future funding rounds and company credibility.
Looking Forward: Liquidity Events
In our next post, we’ll dive into what happens during liquidity events — how and when you can finally turn your paper wealth into real cash. We’ll cover IPOs, acquisitions, and the less common but increasingly interesting secondary markets for private company shares. So if you are new here please subscribe to my Substack to stay informed and get my articles a few days earlier.
Conclusion
Understanding your ISOs, the impact of valuation practices on your taxes with AMT, and the strategic maneuvers startups may play with their 409A valuations are very important for evaluating your startup job offer. It’s not just about what you own on paper, but also what you might owe to the IRS and when you might see real money.
