Rule 409A

Rule 409A of the Internal Revenue Code is intended to prevent Enron-era abuses with respect to the valuation of stock options.  The general rule of thumb is that the excercise price of stock options must be equal to the fair market value of the company’s stock at the time of grant.  This, of course, is tricky business for private companies to comply with, since by nature there is no relevant market against which the company can be valued (for public company’s you can easily obtain their valuation in open market).  There is a specific list of factors that boards of directors must consider in determining the valuation of the company at the time such stock options are issued, and the board needs to take care that it carefully considers all such factors in determining fair market value. 

The penalties for not complying with 409A are pretty harsh - immediate regonition of ordinary income plus a potential 20% penalty.   Get a lawyer and/or an accountant on board if you are wading into this tricky territory.

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