We're back with part 2 of our Q&A on 409A valuations. If you haven't read it, check out part 1 here. 409A valuations come into play once founders and management start thinking about their first hires, so understanding them early is important. We'll have more posts on the topic, which will deal with finer points, but let's finish up the Q&A with our friend and valuation expert, Bo Brustkern.
Bo is Managing Director and founder of Arcstone Partners, a business valuation firm, and he has over 17 years of experience as an investment and valuation professional. He has been quoted in a variety of publications, including The New York Times and Financial Times.
EZ: What are the safe harbors for 409A valuation and why do they matter?
The reason the 409A safe harbor is so important is that it shifts the burden of proof to the IRS, meaning the company’s valuation is presumed to be correct unless proven grossly unreasonable.
There are several safe harbor methods outlined in the 409A code, including:
1) the illiquid start-up,
2) binding formula, and
3) independent appraisal approaches.
In order for any of the safe harbors to comply, the method must incorporate evaluation of a number of factors, including: (i) the value of tangible and intangible assets of the company, (ii) the present value of future cash flows, (iii) the public trading price or private sale price of comparable companies, (iv) control premiums and discounts for lack of marketability, (v) whether the method is used for other purposes, and (v) whether all available information is taken into account in determining value. Simply put, section 409A allows a company to find a safe harbor within the Code by obtaining an appraisal of company stock by an established firm practiced in the art of business valuation.
Pro tip: so guess which reports go to the top of the IRS’ prosecution stack? Internally produced valuations, and those conducted by black-box “fully-automated” software-based valuations, which do not fit the safe harbor test.
EZ: Can a company do its own 409A valuation? What are the requirements?
A company is allowed to do its 409A valuation in-house (although it’s usually not a good idea). The 409A regulations allow “persons with significant knowledge and experience or training in performing similar valuations” to conduct a valuation for 409A purposes and stay within the safe harbors allowed by 409A. The IRS takes care to define “significant” as having at least five years of expertise in “performing similar valuations.” Clearly, a VC or PE investor, or board member, or CFO “values” companies all the time. However, very rarely have we known any such person that actually has so much expertise performing similar valuations, for 409A valuations are very particular and nuanced in their execution.
Note the following observation from the Herbert vs. Kohler (2006) tax court case, per the industry rag Business Valuation Review:
“The taxpayer prevailed on this argument because their witnesses were highly qualified and they followed generally accepted valuation approaches. The court noted that the experts were certified appraisers. The court was impressed by the valuation methodologies used and the conclusions of the taxpayer's appraisers. In addition, the court noted the appraisers' compliance with USPAP [a core valuation standard].”
The court's conclusion highlights the importance of using reputable, qualified, experienced appraisers who follow generally accepted valuation standards, approaches, methods, and procedures.
EZ: What are the pitfalls of issuing options whose exercise price is deemed to be lower than the FMV of the underlying stock?
Lower: major problem. The IRS and others can essentially tax and penalize the employee in major ways, wiping out all the employee's winnings.
Higher: not a problem.
EZ: How much does a 409A valuation from a third party valuation expert cost?
For a seed-stage startup with a $1 million convertible note financing, expect to pay between $3500 and $4500 from firm of reasonable quality and reputation, if they specialize in early stage entities. For a late-stage entity pre-IPO, valuations could run you $8000 to $15000 per valuation, with valuations occurring every 3 to 4 months. Just like legal and audit fees, your budget for financial valuation compliance will expand as your company does. Prepare to spend $4000 in year one and $40000 in year five for valuation compliance.
EZ: Any other issues management should think about relating to stock option valuations?
Yes indeed. We have seen an increasing amount of litigation (e.g., employee vs. company) in the very recent past, leading us to believe that 409A valuations are being used for a variety of purposes beyond just IRS and SEC compliance, and they are setting the stage for fights over valuation after companies succeed or fail. The old “hey you screwed me! See here on the 409A where it says we were worth [x]?!?” To avoid this dispute, or at least be better prepared when it occurs, company management is wise to procure contemporaneous valuations of high quality throughout a company’s life. This alone can make a huge difference for company management as they inevitably face these difficult situations.