Written by Chris Walton, JDOn December 26, 2003, Marvell Technology Group’s executive compensation committee approved a grant of 1.5 million stock options to Sehat Sutardja, the company’s co-founder, CEO, and chairman. The exercise price was set at $36.50 per share — the trading price of Marvell’s stock on that date. Twenty-one days later, on January 16, 2004, the board ratified the grant. By then, Marvell’s stock had risen to $43.64.
That 21-day gap cost Sutardja $5.3 million.
After an internal review of Marvell’s stock option granting practices — part of the broader options backdating investigations that swept through Silicon Valley in 2006 — the company determined that the actual grant date for Sutardja’s options was January 16, 2004 (the ratification date), not December 26, 2003 (the committee approval date). That meant the exercise price of $36.50 was below the fair market value of $43.64 on the grant date. The options were discounted. And discounted stock options, the IRS determined, are nonqualified deferred compensation subject to the 20% penalty tax under Section 409A of the Internal Revenue Code — plus interest at the federal penalty rate.
In Sutardja v. United States (109 Fed. Cl. 358, 2013), the U.S. Court of Federal Claims confirmed the IRS’s position in what was the first judicial ruling on the application of Section 409A to discounted stock options. The court held that discounted options are deferred compensation, that the 20% penalty tax applies, and that the taxpayer’s attempt to correct the exercise price after the fact did not undo the 409A violation. For every company that grants stock options — public or private, startup or mature — Sutardja is the case that proves the IRS is serious about enforcing 409A, and that the grant-date valuation is the moment where compliance is won or lost.
Section 409A was enacted in 2004 in response to the Enron scandal and other abuses involving deferred compensation. The statute imposes strict rules on “nonqualified deferred compensation” — any arrangement under which compensation is earned in one year and paid in a later year. If the arrangement doesn’t comply with 409A’s requirements (regarding the timing of deferral elections and the timing of distributions), the deferred amount is includable in income when it vests, subject to a 20% additional tax, and subject to interest at the underpayment rate plus one percentage point from the date the compensation should have been included in income.
Stock options are generally exempt from 409A — but only if the exercise price is set at or above the fair market value of the underlying stock on the date of grant. This exemption exists because an at-the-money or out-of-the-money option doesn’t “defer” compensation in the traditional sense: the option has no intrinsic value at grant, and the holder receives value only if the stock price appreciates after the grant date. The holder isn’t deferring existing compensation into the future; the holder is receiving a right that has value only if future performance materializes.
A discounted option — one with an exercise price below fair market value on the grant date — is different. The option has intrinsic value at the moment it’s granted: the holder could immediately exercise and receive a profit equal to the spread between the exercise price and the current market value. That built-in value is compensation that exists at grant but isn’t received until exercise. The IRS treats this as a deferral of compensation, and Section 409A’s rules apply. If the option doesn’t comply with 409A’s distribution timing requirements — and standard stock options don’t, because they’re exercisable at the holder’s discretion rather than on 409A-permitted triggers like a fixed date, death, disability, or separation from service — the penalty tax is triggered.
The penalty is severe: 20% of the total gain on the option, in addition to ordinary income tax, plus interest from the date the option vested. On Sutardja’s options, the IRS assessed $5,282,125 in additional taxes and interest. The exercise price was $36.50. Fair market value on the actual grant date was $43.64. The discount was $7.14 per share. The 20% penalty applied to the entire appreciation on exercise — not just the $7.14 discount. The penalty was calculated on the full spread, producing a liability that dwarfed the discount that triggered it.
The factual timeline in Sutardja is important because it illustrates exactly how a grant-date problem arises in practice — and why it’s a problem that affects private companies even more than public ones.
On December 10, 2003, Marvell’s executive compensation committee authorized a grant of up to 2 million stock options to Sutardja. The stock price on that date was $36.19. On December 26, 2003, the committee approved a specific grant of 1.5 million options at an exercise price of $36.50 — the trading price on that date. But the grant was not formally ratified by the board until January 16, 2004, when the stock was trading at $43.64.
The question was: when was the option “granted” for purposes of Section 409A? If the grant date was December 26 (the committee approval), the exercise price of $36.50 matched the fair market value and the option was exempt from 409A. If the grant date was January 16 (the ratification), the exercise price of $36.50 was below the fair market value of $43.64, and the option was discounted.
Marvell’s own internal review concluded that the grant date was January 16. The company reformed the option agreement to correct the exercise price to $43.64 and Sutardja remitted the difference between the original and corrected exercise prices for the portions he had already exercised. But the IRS took the position that the reformation was too late: the option had been granted at a discount on January 16, 2004, and the 409A violation occurred at grant. Correcting the exercise price after the fact did not retroactively cure the noncompliance.
This is the critical point for practitioners: the 409A violation attaches at the moment of grant. If the exercise price is below fair market value on the grant date, the option is nonqualified deferred compensation from that moment forward. No subsequent correction — reforming the option agreement, repricing the exercise price, remitting the difference — can undo the violation. The only cure is to get the grant-date valuation right in the first place.
Sutardja raised four legal theories in his motion for partial summary judgment. The court rejected all four:
Commissioner v. Smith (1945) is inapplicable. Sutardja’s primary argument relied on the Supreme Court’s 1945 decision in Commissioner v. Smith, which held that the granting of a stock option is not a taxable event and that compensation is recognized only upon exercise. The court rejected this argument on narrow grounds: the options in Smith were granted at or above fair market value. The case did not address discounted options. Section 409A, enacted 59 years after Smith, specifically provides that discounted options are deferred compensation. The 1945 precedent is simply irrelevant to the statutory framework Congress created in 2004.
The option was not “deferred compensation.” Sutardja argued that no compensation was deferred because the option had no value until he exercised it. The court disagreed: a discounted option has intrinsic value at grant equal to the spread between the exercise price and the fair market value. That intrinsic value is compensation that exists at grant but is not received until exercise — the definition of deferral. The Treasury Regulations under 409A expressly state that a stock option with an exercise price less than the fair market value of the underlying stock on the date of grant is treated as a deferral of compensation.
The transition period should provide relief. The option was granted in January 2004, before the 409A regulations were finalized. Sutardja argued that the transitional guidance should protect him. The court found that the transition rules did not exempt discounted options from 409A’s requirements. IRS Notice 2005-1, issued during the transition period, explicitly states that options granted with an exercise price below fair market value are subject to 409A. The transition period provided time to come into compliance with the new rules — it did not exempt noncompliant arrangements from the statute.
The good-faith correction should cure the violation. Sutardja reformed the option agreement to correct the exercise price and remitted the difference for the shares he had already exercised. The court found that the good-faith correction did not retroactively cure the 409A noncompliance. The violation occurred at grant. Subsequent corrections address the economic consequences but do not change the legal character of the option at the time it was granted. This is the holding that has the broadest implications: there is no after-the-fact fix for a discounted option.
Marvell was a NASDAQ-traded public company. Its stock had a readily determinable market price every trading day. The grant-date valuation problem arose not from uncertainty about the stock’s value but from a procedural gap — the delay between committee approval and board ratification. The price was knowable; the grant date was contested.
For private companies, the problem is reversed and more dangerous. The stock has no readily determinable market value. The grant-date valuation is not a matter of looking up a closing price; it requires a contemporaneous independent appraisal. If the company doesn’t obtain a 409A valuation before granting options — or if the valuation it obtains is stale, flawed, or not performed by a qualified appraiser — every option granted at the appraised exercise price is potentially discounted. And if the options are discounted, Sutardja confirms that the 20% penalty tax applies to the entire gain on exercise.
The IRS provides a safe harbor for private company stock valuations under Treasury Regulation §1.409A-1(b)(5)(iv). If the valuation is performed by a qualified independent appraiser (meeting specific experience and education requirements), uses generally accepted valuation methods, and is not more than 12 months old at the time of the grant, the valuation is presumed reasonable. The burden shifts to the IRS to prove the valuation is “grossly unreasonable.” Without the safe harbor, the company bears the burden of proving the valuation was reasonable — a much harder position to defend on audit.
This is the connection between Sutardja and every 409A valuation Eton or any other valuation firm performs for a venture-backed company. The 409A valuation sets the exercise price. If the exercise price is at or above fair market value, the options are exempt from 409A. If it’s below — because the valuation was stale, because the company’s circumstances changed after the valuation was performed, because the valuation methodology was flawed, or because the company didn’t get a valuation at all — every option granted at that price is a discounted option, and Sutardja tells you what happens next.
Sutardja was decided during the aftermath of the options backdating scandal that swept through Silicon Valley in 2006 and 2007. Dozens of public companies — including Broadcom, Comverse Technology, UnitedHealth Group, and Marvell itself — were investigated for granting stock options with exercise prices set at historical lows rather than at the actual grant-date price. The mechanics were straightforward: the company would select a date in the past when the stock price was lower and record that date as the “grant date,” producing an exercise price below the actual fair market value on the date the grant was actually approved.
Marvell’s Special Committee concluded that certain option grants had been made with incorrect measurement dates. Sutardja’s grant was among them. Whether the December 26/January 16 discrepancy was intentional backdating or a procedural oversight in the approval process, the tax consequence was the same: a discounted option subject to 409A.
For private companies, the backdating risk is different but the valuation risk is analogous. A private company doesn’t have a stock price to backdate, but it can grant options based on a stale 409A valuation that no longer reflects the company’s current fair market value — because the company raised a new round, signed a significant contract, or experienced material growth since the last appraisal. Using a 409A valuation that is more than 12 months old, or that was prepared before a material event that changed the company’s value, creates the same economic result as backdating: an exercise price below the current fair market value. And Sutardja confirms that the IRS treats the result the same way regardless of the cause.
For companies granting stock options — and for the counsel, boards, and compensation committees approving those grants — Sutardja provides the compliance framework:
Establish the grant date with certainty. The grant date is the date on which the granting entity has taken all necessary corporate action to create a legally binding right. For a public company, that means the date the compensation committee approves the specific grant (not the date it authorizes a general pool). For a private company, that means the date the board approves the grant. If the approval requires ratification, the grant date may be the ratification date — as Marvell’s internal review concluded. Resolve any ambiguity before the grant is made, not after the IRS raises the question.
Set the exercise price at or above fair market value on the grant date. For public companies, fair market value is the closing price (or a permissible average) on the grant date. For private companies, fair market value is determined by an independent 409A valuation that satisfies the safe harbor requirements. The exercise price must be set on the same date the fair market value is measured. A lag between the valuation date and the grant date — even a few days — can produce a discount if the stock appreciates in the interim.
Obtain the 409A valuation before the grant, not after. A 409A valuation prepared after options have already been granted cannot retroactively establish that the exercise price was at or above fair market value. The valuation must be in hand before the board approves the grant. If the company is approaching a grant date and the current 409A valuation is stale or approaching its 12-month expiration, obtain a new valuation before granting.
Update the valuation after material events. A 409A valuation that was accurate when prepared can become stale if the company experiences a material event: a new funding round, a significant customer contract, a change in financial performance, or a term sheet for an acquisition. The safe harbor presumes the valuation is reasonable for 12 months, but that presumption may not hold if the company’s circumstances have materially changed. A supplemental valuation or a new appraisal may be required to ensure the exercise price still reflects fair market value.
Do not attempt to cure a discount after the fact. Sutardja tried. He reformed the option agreement, corrected the exercise price, and remitted the difference. The court found none of these corrections cured the 409A violation. The violation attaches at grant and cannot be undone. The only remedy is to get it right at grant — or, if the company discovers a potential discount after granting, to consult tax counsel immediately about the limited correction programs the IRS has made available under Notice 2008-113 and similar guidance (which impose their own requirements and deadlines).
Sutardja and Jacobs v. Akademos (Del. Ch. 2024) bookend the 409A practitioner’s world. Sutardja shows what happens when the 409A valuation is wrong — the exercise price is below fair market value, the options are discounted, and the 20% penalty tax applies. Akademos shows what happens when the 409A valuation is right for tax purposes but doesn’t reflect what the stock is worth in litigation — the OPM assigns value to common stock for 409A compliance, but the court finds the common worthless because the preferred stack absorbs all enterprise value.
Together, the two cases define the boundaries of the 409A valuation engagement. The 409A valuation must be high enough to satisfy 409A — the exercise price must be at or above fair market value, or the options are discounted and Sutardja applies. But the 409A valuation is not a representation of what the stock is worth in a sale, an appraisal, or a litigation proceeding — Akademos confirms that the court measures a different question (what the stock is worth now) than the 409A valuation answers (what exercise price is defensible for tax compliance). The 409A practitioner must get the valuation right for its purpose while being clear about what that purpose is and what it doesn’t cover.
Sehat Sutardja was the co-founder, CEO, and chairman of a multibillion-dollar public semiconductor company. He had access to the best tax and legal counsel in Silicon Valley. He attempted to correct the exercise price after the problem was discovered. He remitted the economic difference. He reformed the option agreement. None of it mattered. The 409A violation attached at grant, the 20% penalty tax applied to the entire gain on exercise, and the total assessment was $5.3 million.
For private companies granting stock options: the 409A valuation is the single most important compliance document in the option granting process. If the valuation is current, performed by a qualified independent appraiser, and supports an exercise price at or above fair market value, the options are exempt from 409A and Sutardja doesn’t apply. If the valuation is stale, flawed, or missing — or if the company grants options without one — every option is potentially discounted, and the 20% penalty tax lands on the employees who exercise them. The employees didn’t create the problem. The company did. But under 409A, the employees pay the penalty. After Sutardja, there is no ambiguity about whether the IRS will enforce it. The only question is whether the company’s grant-date valuation will hold.
If you need a 409A valuation before an upcoming option grant, or need to evaluate whether a prior valuation is still current after a material event, happy to discuss the engagement scope. The grant-date valuation is where 409A compliance is determined — and after Sutardja, getting it wrong is a $5 million problem.
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