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I've been reading that under 409a regulations, if non-qualified stock options are issued below fair market value, there are immediate tax implications and a 20% penalty. I've been working part-time for a startup and am being issued non-qualified options but have been told that there won't be a valuation of the company until the first round of seed investment is completed in a couple months.

So I'm wondering what happens in this situation and if this will cause issues? I read in another question (OK to issue options before the first financing round?) that early on the fair market value is close to zero but isn't it important to get a valuation? And what happens if they don't have one at the time options are issued?

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So, first of all, you can avoid 409A by getting restricted stock instead of options. Yes, you have to pay out a little bit of cash (a very little bit), but then valuation issues go away.

In general, though, for early stage companies, the board usually says "This is what we think the value is" -- it's a nominal amount, because the company has nominal assets. A valuation at that point would be almost complete guesswork.

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it may be guesswork, but it will satisfy the IRS if it's guesswork prepared in a disciplined way by a reputable 409a valuation firm – Joel Spolsky♦ Mar 19 at 20:40
Thanks for the responses. I'll have to research restricted stock. But it sounds like for NSO's there could be a problem (for me and for the startup) if they are issued now without a valuation... since there'd be no way to determine if they're below fair market value (and if so, how much below)? – KevinVictor Mar 20 at 13:13
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What normally happens in this situation is that the company doesn't issue the options until the valuation is done. At our company we've had to delay issuing options to new employees, sometimes by as much as 6 months, while we finish financing rounds and get 409a valuations in place. We often accelerate the vesting in these cases to compensate.

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