IRC 409A became applicable to employee stock options six years ago. It triggered a need for private companies that grant stock options to have their common stock valued approximately once a year. Enterprise Valuations specializes in 409A valuations and has completed hundreds of them for new and repeat clients during the last five years.
· Since the introduction of the 409A valuation requirements, the Internal Revenue Service has shown little interest in their enforcement. I am not aware of a single client whose stock option prices and valuations have been scrutinized by the IRS. I doubt that it is a total goose egg but it certainly hasn’t been a high priority for the Service.
· Although 409A valuations are not mandatory, they are advisable and a large majority of private companies using stock options have chosen to have valuations done on annual regular basis. There are at least two good reasons for having a 409A valuation done for your company as part of your annual compliance cycle (similar to filing a tax return):
1. A valuation creates a safe harbor that protects your employee option holders against some potentially very onerous tax penalties including Federal tax penalties of 20%, comparable state tax penalties (at least in California) and being obligated to pay taxes on hypothetical stock gains before they are actually realized.
2. A valuation also protects the company from being required to withhold on real or illusory employee stock option gains as the options vest (or from suffering the consequences of failing to properly withhold taxes from employee paychecks).
· For most companies, a 409A valuation is an irritant at best. It doesn’t add value to the company so it is a very low priority for use of the company’s limited capital. It takes management time away from other much more important priorities. And sometimes the resulting common stock valuation (which must conform with professional valuation standards) is considerably higher than the pre-409A “10% of the latest preferred” rule of thumb, with the obvious disadvantage of increasing the cost of exercising options for your key employees. Those all are valid objections.
· Although the IRS has shown little interest in 409A valuations, the same cannot be said for the major accounting firms. They routinely attempt to use the 409A valuations in connection with their annual audits of those private companies that have reached the point of having an audit. This often has been the source of considerable delay and added cost for the companies being audited – particularly in the early years of 409A valuations.
· Having done hundreds of 409A valuations, I can say without hesitation that doing a 409A valuation “properly” is not a trivial undertaking. By “properly”, I mean that it is done using generally accepted valuation assumptions and methods so that the resulting valuation report and conclusions can be successfully defended with the IRS and your accounting firm.
· There are many individuals and small valuation firms that offer to conduct 409A valuations but not all of them have the requisite knowledge and experience to do the job properly.
What makes the most sense for your company? Here are a few of my thoughts, not from an appraiser’s perspective but as someone who has served as Chief Financial Officer and corporate legal counsel for a wide range of companies and helped them manage their business and legal risks:
· First, remember that the 409A issues only come into play for your company if you are granting stock options (or providing similar equity incentives such as stock appreciation rights) to employees or other service providers. If you are not doing so, you can take a pass on 409A valuations (although your accountants may someday ask for something similar for accounting purposes).
· If you are wondering whether your company has reached the point at which a 409A valuation is advisable, start with your company legal counsel. Corporate lawyers – particularly those that work with venture-funded startups – are very familiar with 409A and are likely to be your best source of advice on this subject.
· Be pragmatic. 409A valuations have become just another one of the facts of life in corporate America. As annoying as it may be to spend time and money on something that contributes little or nothing to your value creation process, a valuation isn’t that expensive and if done properly, it does insulate your employee stock options from some seriously adverse tax consequences.
· From my experience, most companies that use employee stock options begin having 409A valuations done immediately following the completion of their first venture round (Series A), having been encouraged to do so by legal counsel. Increasingly, I am seeing the process backing up to an even earlier point, particularly if there is angel financing involved.
· Once you have decided to have a 409A valuation done, be diligent in the selection of an appraiser or valuation firm to carry out the project for your company. In an effort to minimize cost, this issue is often not given adequate attention. However, the 409A regulations are very clear that the safe harbor created by a 409A valuation only arises if the valuation was prepared by a qualified appraiser.
· How do you know if someone is a qualified appraiser? The IRS regulations are thin on specifics regarding what it takes to be classified as a qualified appraiser. Based on my research, the criteria I would suggest you apply at a minimum consist of i) extensive previous experience doing 409A valuations, ii) valuation accreditation by at least one of the professional valuation organizations (AVA, NACVA, AICPA, etc.), and iii) a thorough understanding and significant experience applying the allocation methods described in the AICPA Practice Aid related to the valuation of private company equity securities. Experience working through valuation issues with accounting firms is also desirable (not essential for 409A but very important for your independent audit).
· When you are in the evaluation and selection process, narrow your candidate group to those who pass the qualifications test before applying the price screen. It only makes sense to be price sensitive when you are buying something that is low on your priority list. However, many early stage companies seem to focus on price exclusively or above all else. But if the low price offer isn’t from someone who clearly passes the qualifications screening, why take a chance? Many well qualified appraisers are very price competitive. The cost of not using the lowest price offer is likely to be a couple of thousand dollars at the most. The cost of being wrong on qualifications issue could be orders of magnitude greater for the company and its option holders.
About the Author
Bruce Pollock has served as Chief Financial Officer for several high technology companies, including public companies Avanex Corporation, Walker Interactive Systems Inc. and VMX, Inc. and private companies WaveSplitter Technologies, Opcom and Reel.com. He also has served as General Counsel for several of these and other companies.
Mr. Pollock’s industry experience includes telecommunications systems, enterprise software, internet commerce, software as a service, optical components and subsystems and wireless software and infrastructure. He is experienced with both high growth and turnaround environments.
Mr. Pollock founded Enterprise Valuations, Inc. in 2006 and since that time has completed valuations of hundreds of private technology companies and their equity securities for 409A and other purposes. Mr. Pollock received his Bachelor of Science degree from the University of Washington. He also earned an MBA degree from the Haas School of Business (UC Berkeley) and a JD degree from Boalt Law School (UC Berkeley). He is a member of the California Bar and is an Accredited Valuation Analyst (AVA).