But those numbers are still colossal, even when reduced by an order of magnitude or two.
The IRS guidelines say the spread between grant price and fair market valuation. If there's a secondary market, that's your fair market, not 409A (which is a joke anyway).
Also, most companies use the last public valuation as a basis for 409A valuation rather than hiring someone to do it in a separate process. The investors buying shares are the experts here. Of course there are considerations for preferred vs common stock and things like warrants, but they start at the top line number from the last round.
Also there are lots of secondary markets for private companies right now. What makes you think otherwise?
'never' is wrong, depending on your meaning. It's definitely used in many 409A valuations. Typically a 409A will use a couple different approaches to come up with the initial valuation -- it will look at the discounted cash flow, the value of assets and liabilities, and generally will look at 'guideline companies' and their public valuations or cash value upon sale. Once one or more (often times all) of these methods are used for the initial valuation, the value is fed into a Black-Scholes model. That price (after applying discounts for non-marketability) is used as the fair market value for the common stock.
As for real world proof of Black Scholes being garbage, it doesn't get any better than Long Term Capital Management.
Edit: people buying/selling options are of course performing their own pricing operations. They don't care how the market price is determined, since they believe their model is the best and gives more accurate prices than anyone else.
Edit 2: furthermore, to properly price startup options, you need to account for their 'random-expiration' nature: we have no idea when Uber will IPO. this makes it difficult to use traditional option pricing models which have fixed maturities (you can take integrals over the model's results at each possible maturity). additionally, choosing a discount rate is hard when realizing that most employees are not well-diversified, unlike the investors/funds that the traditional models are written for
While neither are great, binomial is better for American style options than BS.
I guess you could choose an arbitrarily distant expiration date, but my bigger point was that while BS is clearly not going to give perfect results, the results are reasonable enough and transparent enough to justify their use for tax purposes in lieu of actual market prices.
As for 409A valuation, I've never heard of an auditor seriously examining it or questioning its validity. It's mostly the "valuation expert" says, "What value do you want for 409A?" You tell them, they ask to see the books, and then say "OK I can sign off on that."
Most companies push the 409A valuations as low as possible precisely because of income tax ramifications on exercise.
If your company says the 409A is $1.50/share but people are selling on secondary markets for $4/share, you must use $4/share when computing your exercise benefit.
If there's no secondary market, it's the last 409A value.
From what I can tell, taxes will be based on the values in Form 3921 (for ISOs and ESPPs), which is delivered by the employer.[0]
Here's a sample 3921.[1] The FMV is delivered in Box 4. My question is where does that value come from? Is it the last 409A valuation, or is it required to use sale data from secondary markets?
I've received several of these forms over the years, and the FMV has always been the value from the last 409A. I have no idea if there was a secondary market for the shares.
I worked at a place that didn't issue 3921's (in the .com go round). I had a hell of a time reaching someone still at the company who could give me that information almost a year later (and after several rounds of devastating layoffs). I really don't know what she based the figure on.
[0] http://www.startuplawblog.com/2011/01/05/companies-remember-...