Using In-the-Money Stock Options Without Violating 409A

As we often do, let’s start with some good news.  We have a new partner, Tom Greene, who has been practicing in employee benefits and executive compensation for almost 20 years.  In addition to his traditional ERISA practice, Tom is already making a difference in our core M&A practice with his deft handling of 409A, 280G, ISO, plan termination, and benefits diligence issues for buyers, sellers, and management teams.

In Tom’s honor, this edition of the Issue Spotter examines how in-the-money stock options may be useful to growth companies.  For this discussion, “in-the-money” means the strike price is below the fair market value of the underlying stock on the date of grant, and “growth company” means a relatively young private company whose equity and option holders intend to profit from capital appreciation in a sale of the whole company (rather than through distributions of operating profits or isolated equity sales).

Fun fact:  409A does not prohibit in-the-money stock options

Conventional wisdom says non-qualified options violate § 409A unless the strike price is at least equal to the fair market value of the underlying stock on the date the options are granted.  Ensuring an “FMV strike price” is generally a good idea for business, securities compliance, and other non-tax reasons, but it isn’t absolutely required by § 409A.

To set the stage, remember that § 409A regulates the timing of deferrals and payments for “deferred compensation plans.”  Generally, common stock options with an FMV strike price are not deferred compensation plans, and are thus exempt from § 409A.  Needless to say, being exempt from § 409A means broad flexibility in designing the vesting and exercise provisions for such options, making one’s life a lot easier.

Options issued in-the-money, however, are deferred compensation plans under § 409A.  While they aren’t exempt from § 409A, they can comply with it by, among other criteria, limiting and requiring exercise upon the earliest to occur of one or more of six permissible payment events:  death, disability, an unforeseen emergency, a specified time or fixed schedule, and, most importantly for growth companies, a change of control or separation from service.

How in-the-money options may be useful

Here’s what makes in-the-money options a real possibility for growth companies:  very few option holders ever actually exercise their options prior to a liquidity event or, to a lesser extent, a termination of employment.  It’s only a slight exaggeration to say that a typical option holder would barely notice if his or her options could only be exercised on the earlier of a change of control and/or separation from service.  With such restrictions on exercise, the options could comply with § 409A even if the strike price were below the fair market value of the underlying stock when granted.

While not normally the preferred approach, options with a nominal or below FMV strike price may be useful in certain circumstances.  Most obviously, the company and a new executive may want the executive to share in proceeds from a sale transaction from “dollar one,” that is, based on the entire per-share value upon the sale rather than just the spread between the sale value and the exercise price.  Or two or more employees may join the company and receive options at different times but, for various reasons, wish to receive similar equity compensation packages.  Startup advisors will recognize another example — a founder may have verbally promised options to certain employees, and the company may even have adopted an option plan and authorize options grants, but the options are never actually granted to the employees until the company’s stock has substantially increased in value.

Complying with, rather than being exempt from, § 409A has some distinct disadvantages, which is why “FMV strike price” is more common.  Most significant is the issue of “subsequent deferral.”  Subject to some rare exceptions, in-the-money options (like all deferred compensation plans) must be exercised or cashed out upon the relevant payment event, even if the option holder doesn’t receive sufficient cash to pay the resulting taxes.  For instance, the change of control may be a stock-for-stock reorganization with no cash consideration, or the separation from service may not include a sufficient severance package.  Drafting around this risk may involve additional advance planning and negotiation.


Issuing stock options with an “FMV strike price” surely makes tax and other legal compliance easier, but it is not absolutely required by § 409A.  There are circumstances in which in-the-money options may be useful.  Such options comply with § 409A as long as exercise is limited to and required upon certain events, most notably a change of control or separation from service.

For more information, please contact Travis Blais or Tom Greene.

Robert Murphy