It seems reasonable that the trigger for a challenge to a 409A valuation will be the audit of a high income shareholder following a liquidity event for the company (who received large grants of stock options – see Sutardja for an example of one such optionee) – in other words, years after the original valuation and strike price were set. This takes on significance because the clock on the underpayment interest starts at the time of vesting, so it is not improbable that there may be 5 to 10 years of accrued interest that will be due, in addition to penalties. Furthermore, it may be difficult to find the valuator who initially performed the valuation, leaving the document to defend itself. As you will see below, non-compliance cost our hypothetical taxpayer at least $1,000,000 or 40% of the proceeds – probably substantially more with the imputed interest on the underpayment as well as tax and legal fees.

Let’s look at the math:

Notes:
(a) As later determined by the IRS
(b) Assumes highest tax bracket in 2013
(c) On amounts includable in taxable income
* Before underpayment interest due from vesting date (3% to each of the IRS and FTB, 6% combined).

It is rational to assume that the respective taxing authorities would not stop with this taxpayer if such bounty is available from other shareholders. Likely targets include all senior level executives and employees who received sizable option grants – and therefore, have potentially large tax bills. There may be additional charges to the company (and perhaps restatements) to the extent the taxing authorities determine that the shareholder is under withheld relative to the implied income from the mispriced options.

The Bottom Line
IRC 409A is a mine field for those who play at its boundaries, potentially being left with an indefensible opinion gotten during their watch. While serious financial costs for the employee/optionee accrue, the management, Board, and company are likely to suffer even more punitive consequences.

Also on the table, but difficult to quantify, are the lost gains to the optionees resulting from strike prices that were set higher than necessary because of errors (including errors in judgment) in the valuation analysis. The bottom line is that it’s not only important to get a competent, defensible opinion, but also one that optimizes the outcome for all constituent parties (including accountants and taxing authorities).

Hopefully, you leave this discussion with a better understanding of how a poorly prepared valuation can destroy lots of bank accounts, not to mention lives and livelihoods. Those who get the message will begin to probe and challenge the quality of the valuators and valuations being offered in their defense when the accountants and IRS call.

Part I of this series describes some ways to test the credentials of a valuation firm and avoid a poor-quality valuation. The discussion in Part II quantifies the magnitude of expected fees for defending a poor-quality valuation. And read more about What Makes a Good 409A Valuation.

John Heath is Executive Vice President, Valuations & Financial Advisory Services of The Brenner Group. John joined The Brenner Group® in 1994 and manages the firm’s Valuations and Financial Advisory Services Groups. John has more than thirty-five years of experience in corporate finance, and has assisted more than 600 companies with financing, public underwritings, mergers, acquisitions, and valuations. Prior to joining The Brenner Group, John held executive management positions at Smith Barney, The First National Bank of Chicago, and Price Waterhouse. He received an MBA in Finance from The Wharton School of Business, and a BA degree from the University of Pennsylvania. John is a member and Accredited Senior Appraiser of the American Society of Appraisers and a member of the Appraisal Issues Task Force.

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Optimistically, the completed opinion is furnished within a month, option grants are made, and silence reigns. All is forgotten until an event occurs, probably years later (nearly 10 years for the IRS case against Sutardja), and management (which may be new since the original valuation) is left scrambling to find the opinion, and more problematic, find the valuator that can defend it. Typical events include the following:

1. The company hires accountants for a financial audit (there may be subsequent SEC reviews)
2. The company is being acquired
3. The IRS audits a major optionee (likely to be a C suite executive)

In each of these cases, the valuation opinion will be reviewed – for financial reporting compliance in the case of 1 and 2 immediately above, and for tax compliance in the case of 2 and 3. Our pending example will deal specifically with either 1 or 2, as the IRS has reviewed many tax valuations (for estate and gift purposes) but none of note for 409A compliance has been fully adjudicated.

Costs of Non-Compliance: An Example
If there are significant issues with the valuation analysis, the accounting firm’s valuation group may recommend to the client at the outset to seek a new opinion from a known valuation firm. Companies will be tempted to resist that suggestion as it implies there may be a change in the concluded value and it comes with a price tag that may be $10,000 to $20,000, or more. If the decision is to try to defend the existing opinion, the time racked up by the accounting firm and the valuation firm in responding to interrogatories and conference calls could easily approach $35,000. If a successful defense is the result then it may well have cost the company more than $40,000 for that opinion. However, if the challenge is sustained, then a new valuation will need to be performed. Our bargain valuation will now have cost in excess of $50,000, probably three times or more the fee of the highest priced vendor on the initial bid.

Summarized in the following table are the incremental costs relative to an opinion which does not stand up to peer review and one that does:

 
Before we leave the discussion of expenses related to the accounting review, the company may yet have to face additional challenges to its 409A valuation from an acquirer’s due diligence if it is sold or from the SEC if the company makes it to registration. In these cases, delay stemming from poor compliance may impact critical time-sensitive negotiations, and resultant transaction values.

More Challenges and Expenses
Up to this point, we have only considered challenges mounted by accounting firms to test the company’s compliance with ASC 718, expensing of equity based compensation (soft expenses – and as you will soon see, the company has been fielding only soft balls to this point). It’s time to deal with the big, hairy gorilla in the room – the IRS and 409A Valuations – discussed in Part III  of this series.

Part I of this series describes some ways to test the credentials of the valuation firm. And read more about What Makes a Good 409A Valuation.

John Heath is Executive Vice President, Valuations & Financial Advisory Services of The Brenner Group. John joined The Brenner Group® in 1994 and manages the firm’s Valuations and Financial Advisory Services Groups. John has more than thirty-five years of experience in corporate finance, and has assisted more than 600 companies with financing, public underwritings, mergers, acquisitions, and valuations. Prior to joining The Brenner Group, John held executive management positions at Smith Barney, The First National Bank of Chicago, and Price Waterhouse. He received an MBA in Finance from The Wharton School of Business, and a BA degree from the University of Pennsylvania. John is a member and Accredited Senior Appraiser of the American Society of Appraisers and a member of the Appraisal Issues Task Force.

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One such field that gets lots of play is the compliance valuation performed primarily for IRC 409A to justify private company stock option strike prices, and secondarily for ASC 718 to account for equity based compensation. Introduced by their respective tax and accounting jurisdictional bodies almost 10 years ago, the initial fear generated in the community of private companies (and public as we are now learning) was immediate and without parallel – the golden goose (cheap options) was under attack and no expense was too great in light of the potential gains from low priced options.

409A Valuation Compliance: Cost vs. Quality
As time passed, silence from the IRS prevailed(1) ; financial auditors in the aftermath of the Enron debacle filled the void, reaching an accommodation with valuation service providers after imposing their methodologies and biases; and the emphasis shifted from the premium placed on the “quality” of compliance to the “cost” of compliance. That shift in attitude was driven in part by investors who informed their portfolio companies following the 2008 financial crisis that cash burn was to be minimized, and worse yet, that additional financing was unlikely. While budgets were whacked to a pulp, the original purpose of securing the valuation to obtain a defensible opinion that met management’s objectives became subservient to “check the box” compliance at the least cost.

Indeed, we frequently see early stage companies buying 409A valuation services without regard to the quality of the work, the outcome, or the potential risks that lie ahead – unfortunately, as others identified these concerns years ago, this is a pervasive threat to defensible compliance. The reason is in part due to a superficial understanding of what constitutes a quality analysis and to ignorance of the real costs of non-compliance. To understand the quality issues, one would need to be conversant in valuation theory and practice, which is beyond the limited scope of this article. However, being sensitive to a few high-level metrics listed below may help the unwary in the search for a quality valuation firm

Test the credentials of the valuation firm and its professionals:

• How long in business
• Who are their clients, referral sources, partners
• How many valuation opinions issued
• How many of these opinions have been audited and successfully defended
• What is the scope of valuation services offered (tax, financial reporting, litigation, transaction)
• How knowledgeable about your industry, your business model, and your stage of development
• How conversant with your capital structure
• Where are its valuation professionals located
• Are they available on short notice and are they responsive

Because most buyers are not capable of sorting through the qualitative considerations, they default to the amount of fees they will incur as the basis of their decision. In reality, some lower-priced opinions are superior to more highly-priced ones. Nevertheless, it requires an understanding of more than the fees paid, you need a thorough analysis of the valuation to make a determination of its quality.

The Expenses of Poor Compliance
Perhaps a quantification of some of the expenses resulting from poor compliance will make a bigger impression than attempting to explain and quantify the many judgments that are required for a thorough and defensible valuation analysis. In so doing, hopefully buyers and beneficiaries (employees, optionees, management, and directors) of such services will begin to prioritize what’s really at stake and focus on the competence of their valuation service provider to furnish a defensible argument to those who will challenge the opinion.

Valuation expenses can be categorized into buckets:
1. Fee paid for the valuation opinion
2. Fees paid to both the valuation firm and accounting firm to review the opinion
3. Implied cost of senior management time (CEO/CFO) to referee the two

If the opinion is well prepared, documented, and defended, then the process should end after a reasonably cursory review by the accounting firm and, hopefully, nominal incremental fees.

However, if the reviewing entity cannot achieve comfort in the analyses and responses of the valuation firm, it may be necessary to have a different valuation firm undertake a new opinion, requiring more fees and more review and more management time. One can safely assume that the revised opinion’s outcome will be a higher strike price than that originally used for the option grants (it was probably a low value that triggered the auditor’s review in the first place); it will also cost significantly more than the original opinion.

Compliance Consequences
The implications of resetting to a higher strike price on options that have already been granted are profound and will have devastating impacts on optionees, management, and the Board, calling into question the judgment of those responsible for managing the original valuation project. For the unfortunate, jobs and careers may be on the line.

Note 1: This may be about to change as there is a case before the Federal Court of Claims (Sutardja v. United States) in which the IRS is asserting 409A penalties for underpriced options against the CEO of publicly traded Marvell (MRVL).

The discussion in Part II quantifies the magnitude of expected fees for defending a valuation of poor quality. In Part III, the penalties imposed by the IRS and state (CA) are examined. And read more about What Makes a Good 409A Valuation.

John Heath is Executive Vice President, Valuations & Financial Advisory Services of The Brenner Group. John joined The Brenner Group® in 1994 and manages the firm’s Valuations and Financial Advisory Services Groups. John has more than thirty-five years of experience in corporate finance, and has assisted more than 600 companies with financing, public underwritings, mergers, acquisitions, and valuations. Prior to joining The Brenner Group, John held executive management positions at Smith Barney, The First National Bank of Chicago, and Price Waterhouse. He received an MBA in Finance from The Wharton School of Business, and a BA degree from the University of Pennsylvania. John is an Accredited Senior Appraiser and a member of the Appraisal Issues Task Force.

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It appears the next step in the litigation will be a trial. Whether the IRS will prevail depends on a finding that the options were not issued at fair market value (FMV), i.e., they were priced at a discount to FMV. If the IRS succeeds and California assesses it’s corresponding penalties and interest then much of the gain will be absorbed by the penalties and interest from both the IRS and CA Franchise Tax Board!

Taxpayer lost Round 2 against the IRS

The essence of the taxpayer’s case (Sutardja v. United States PDF) involves a claim for refund of taxes and 409A penalties and interest paid by Dr. Sehat Sutardja and his wife relating to an option granted to him in 2004 and partially exercised in 2006. In Round One, the IRS was not impressed by the taxpayer’s arguments and assessed penalties and interest against him for deferred income subject to IRC 409A. In Round Two, the Court of Federal Claims upheld the IRS’ defense of motions brought by the taxpayer.

Dr. Sutardja is the CEO and one of the founders of Marvell, a $3.4 billion publicly traded semiconductor company with USA headquarters in Silicon Valley. The amount in dispute exceeds $5 million and is calculated from the time of vesting, not exercise, as specified in the Code.

In the ruling issued on February 27, 2013, Judge Thomas C. Wheeler dismissed Dr. Sutardja’s claims that the option grant is not:

• a taxable event, or
• deferred compensation, or
• his legal property prior to exercise, or
• it qualifies under the short term deferral exception

409A: a cautionary tale for companies with option plans

A number of interested followers have commented on the outcome of these rulings, including Morgan Lewis and Winston & Strawn. While none is surprised that the IRS has found a 409A case to pursue, there is some surprise that it has decided to do so given the facts.

Although this case deals specifically with circumstances involving a publicly traded company, the findings of the court will have broad implications for all companies issuing incentive stock options to their employees and management.

There are very consequential outcomes if the IRS prevails at trial not only for Dr. Sutardja relating to any penalties and interest due the IRS but also those that California may assess (their statute also requires a 20% penalty and interest on income subject to 409A). Perhaps not so lingering is the matter of what recourse Dr. Sutardja may seek from Marvel and the Board.

The critical message to this action by the Tax Court? Many companies offer deferred compensation packages such as stock option plans and all would be advised to make sure they are in compliance with 409A provisions: produce no less than an annual independent fair market valuation of the common stock and do so with a proven and credible provider whose valuation will stand up to IRS scrutiny.

John Heath is Executive Vice President, Valuations & Financial Advisory Services of The Brenner Group. John joined The Brenner Group® in 1994 and manages the firm’s Valuations and Financial Advisory Services Groups. John has more than thirty-five years of experience in corporate finance, and has assisted more than 600 companies with financing, public underwritings, mergers, acquisitions, and valuations. Prior to joining The Brenner Group, John held executive management positions at Smith Barney, The First National Bank of Chicago, and Price Waterhouse. He received an MBA in Finance from The Wharton School of Business, and a BA degree from the University of Pennsylvania. John is an Accredited Senior Appraiser and a member of the Appraisal Issues Task Force.

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Angels are now the logical financing source for most early stage companies

So, where does the capital come from to fund these early stage companies? Individual angels still exist, but the more sophisticated of the angels belong to at least one of the organized and established angel groups. Organized angel groups, such as the Band of Angels, The Angels Forum, Sand Hill Angels, Life Science Angels and many more have been working hard to fill the void left by the venture capital funds moving up market.

As an active angel investor with one or more of these groups, I have watched a steadily increasing problem arise. We believe that most venture capitalists are able to have a very high return on about 15% – 20% of their portfolio companies, and have either a breakeven or negative return on the rest. It is also true that organized angel groups, in general, have lower returns than the venture industry, and individual angels do not normally make any significant returns on investments.

Challenges for angel investors

What makes matters worse for angels is that if a deal starts looking like it can become a success and needs to raise large amounts of additional capital, the company usually goes to the established venture capital firms. Unfortunately VCs often try to dilute the angels who took the majority of the risk with the early stage company, to a point where the angels ROI on a successful deal diminishes to an insignificant level. This is further causing the angels, both individual and organized groups, to consider new factors when looking at prospective transactions.

These new factors center on:

• How much cash is required now to get the company to a meaningful milestone or two;

• What will the pre and post money value of the transaction be;

• How much additional equity does the company feel will be needed to get to cash breakeven or exit; and

• What is the exit strategy and timing?

So, when looking at a potential investment, not only do angels have to look at the things we have always looked at: quality of the business model, the management team and the technology; we now need to consider these additional facts.

Key for angels is capital efficiency

We now look for companies that are extremely capital efficient. We look for the initial investment to be within the range of angel investments, typically below $1 million for the first round. And we now look to where the next round of capital will be coming from. We try and identify who will be the next capital in a deal and get the future capital source interested before we even make the the early stage investment. Personally, I try to find transactions for the organized angel groups with which I work that have the following characteristics, at a minimum:

• A great, experienced management team;

• The Total Addressable Market (TAM) is huge, offering a large opportunity to create a business, and not simply a small product;

• Technology which is not so unrealistic, as to prove impossible to achieve;

• Defensible intellectual property;

• A pre money value that can give us, as the high risk investors, a proper rate of return for the inherent risk that we are taking;

• The total amount required to reach cash breakeven will be less than ~5 X what we invest in the first round;

• A group of investors who are interested in following the company and could be probable investors in a subsequent round of capital raised; and

• A likely exit in 3 – 5 years, with a significant ROI.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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Some of Kauffman’s findings from their experience with 100 VC funds over 20 years are frightening to those of us rooting for a healthy VC industry:

• “VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC.”

• “Only twenty of 100 venture funds generated returns that beat a public-market equivalent by more than 3 percent annually, and half of those began investing prior to 1995.”

• “Only four of thirty venture capital funds with committed capital of more than $400 million delivered returns better than those available from a publicly traded small cap common stock index.”

• “The average VC fund fails to return investor capital after fees.”

So it is not surprising to see that in 2012 VCs are raising less capital ($16B so far) than they are investing ($20B so far, or about $6.5B per quarter) according to PricewaterhouseCoopers. One would rightfully conclude that given the poor performance of traditional VCs over the last 10-15 years, their current activity reflects the appropriate consolidation and restructuring of that business.

In and of itself this dynamic is the epitome of a shrinking market and would seem potentially damaging to the long term prospects for the tech sector.

Angels and Corporate VCs trend up

But juxtaposed to the contraction institutional investors are undergoing is the continuing strong activity among other sources of venture capital: angels and corporate VCs. An SVB study, The Halo Report earlier this year showed that angel investors pumped almost $500M into start-ups in 1H 2012.

Similarly a CB Insights report on the Corporate Investor segment reported that Corporate sponsored venture funds invested $2.1B in Q2 2012 and invested in 15% of all VC deals. Equally important to entrepreneurs is that angels and corporate VCs are showing an ever increasing appetite for seed investments.

So it would appear that angels and Corporate VCs are riding to the rescue of today’s swelling tech entrepreneur class, and that is certainly welcome news. And it makes sense empirically as anyone who has recently visited or done business in San Francisco can attest. Entrepreneurship is everywhere as a slew of start-up office clusters and incubators have attracted countless start-up teams often funded by angels or friends and family. The energy and activity resident there is palpable and shows none of the challenging realities facing the average institutional VC fund.

So perhaps the message for today’s tech entrepreneurs seeking funding is best described by that old adage…something about whenever a door closes somewhere a window opens.

J. Weston (Wes) Rose is Senior Vice president of The Brenner Group, one of Silicon Valley’s premier professional services firms. Wes has enjoyed an extensive career as a C-level operating executive with multiple venture capital backed technology companies and now runs the firm’s interim management and restructuring practices.

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The lifetime gift tax exemption is $5.12 million for individuals and double that amount for married couples pooling their resources – that’s about to change unless the Congress acts before December 31, 2012. If the exemption is allowed to expire, it will revert back to $1.0 million. The IRS’ basic publication on estate and gift taxes can be found in this IRS brochure (PDF).

Get a qualified appraisal

Reuters has recently published an article on the role that appraisers play in valuing gifted assets, along with some practical advice for people trying to get their estate planning up to date. The article stresses the need for qualified appraisers to support the value of gifted assets – be it real estate, stock in private companies, artwork, or other assets. With only four months left before the deadline, Reuters also advises readers to select those qualified appraisers with sufficiently large staffs to handle the rush for appraisals as the deadline nears.

The real test of the appraisal will be years after it is performed, when the IRS challenges it during an audit. Aside from being sufficiently staffed and properly credentialed, the selected valuation firm needs to have the permanency to be available to support and defend its valuation opinion if challenged in the future.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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Crowdfunding rules due from SEC in 2012

In our work with early stage technology companies, most of whom confront daunting funding challenges on the road to building positive cash flows, we believe that any regulatory change which expands the size and depth of the pool of financing sources available to these companies augurs well for preservation of the true venture capital model.

Unfortunately, the SEC has until the end of 2012 to codify the specifics of the rules which will govern this exemption. Given that important legislation is dependent upon the wheels of government actually moving combined with an election later this year, we will be fortunate to see those rules in the next seven months. In the meantime, we’ll look to Facebook’s IPO to keep investor’s interest in the venture asset category.

John is Executive Vice President, Valuations & Financial Advisory Services of The Brenner Group. John joined The Brenner Group® in 1994 and manages the firm’s Valuations and Financial Advisory Services Groups. John has more than thirty-five years of experience in corporate finance, and has assisted more than 600 companies with financing, public underwritings, mergers, acquisitions, and valuations. Prior to joining The Brenner Group, John held executive management positions at Smith Barney, The First National Bank of Chicago, and Price Waterhouse. He received an MBA in Finance from The Wharton School of Business, and a BA degree from the University of Pennsylvania. John is a candidate member of the American Society of Appraisers and a member of the Appraisal Issues Task Force.

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When the dot bomb era exploded, the public clamored for sweeping legislations to put more oversight into public companies. The Sarbanes Oxley Act was the result of the government’s reaction to the public’s demands, and it implemented very strict oversight and constraint on public companies as the answer to fix the public’s lack of confidence.

As a result, the cost to become a public company rose by a large multiple of what it had been before Sarbanes Oxley, as did the cost of being public and filing necessary reports with the SEC each quarter and year. Additionally, executives of public companies faced potentially punitive and criminal charges if they made a mistake. So, many businesses felt that the benefits of gaining liquidity by being public were overshadowed by the high costs associated with going, and being public, and the risks and penalties potentially imposed on management by being a public company.

The Facebook Exception
For those of you who haven’t kept up, the result for us in Silicon Valley was a further obstacle for young companies to become publicly traded firms. The IPO window has effectively been shut since about 2001. Granted, some companies have been able to find a public market for their securities, while others, like Facebook, have found ways around the requirements of public companies by using the Second Market to trade their shares. Shareholders in companies like Facebook have been able to buy and sell their shares in this manner, and the price per share has continued to climb. Earlier this year, Facebook filed their S-1 indicating their intent to become a listed company, and register their shares with the SEC

Easing Sarbanes Oxley IPO Restrictions
With the JOBS Act, the landscape is changing again. Many of the restrictions imposed by Sarbanes Oxley have been eased or removed for companies with a market cap of less than $1 billion, which will include almost all new IPO’s from Silicon Valley, other than Facebook

Following is a brief overview of the IPO On-Ramp portions of the JOBS Act affecting smaller companies finding liquidity in the public markets as presented by Wilson Sonsini Goodrich & Rosati:

Facilitating IPOs For Emerging Growth Companies

• Reduced financial information required
• Confidential review by the SEC of draft registration statements
• Pre- and post-filing communications are allowed with Qualified Institutional Buyers (QIBs) and institutions that are accredited investors
• Analyst research reports are permitted before potential or actual IPOs
• Relaxed restrictions on securities analyst communications

Relaxing Public Reporting Requirements For Emerging Growth Companies

• Auditor attestation on internal controls not required on 10-K
• PCAOB audit rules on auditor rotation/reports generally will not apply
• Compliance relaxed on public company accounting pronouncements
• Advisory votes on executive compensation not required
• Reduced disclosure relating to executive compensation

So, what this is showing me is that our government is now trying to encourage small companies to be able to seek liquidity and funds from the public, and not be overly burdened with the costs of being a public entity.

Further, the JOBS Act will make it easier for private companies to raise capital by amending the SEC rules as described by Wilson Sonsini Goodrich and Rosati:

Easier Access to Private Capital

• General solicitations to accredited investors and Qualified Institutional Buyers
• No broker-dealer registration under certain conditions
• Increased offering size under Regulation A to $50 million
• Higher shareholder threshold for registration and public company reporting

Wilson Sonsini goes on to note:

Unlike the IPO on-ramp provisions of the JOBS Act, the access-to-private-capital provisions of the act clearly require the SEC to engage in rulemaking. While the amendments to Rule 506 are specified to occur within 90 days, the other provisions do not require the SEC to adopt the implementing rules within any specified time period. Accordingly, it is unclear how soon companies will be able to take advantage of the changes to private capital-raising that are made in the JOBS Act….

A Proper Correction or an Overcorrection?
Again, common sense has begun to prevail, as the restrictions are being loosened. The real question that will be discussed in many circles is whether the pendulum is swinging too far back in the other direction. We have shown a history of continually overcorrecting a problem, only to create a new one. Only time will tell if this is the case once again.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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• It must reflect the facts and realities of your company – as it really exists at the date of value. There must be thorough and clear communication with experienced valuation specialists who know how to ask the right questions, solicit the relevant information from you, and advise you on how alternative interpretations of the information you have furnished and the state of the business can impact the results of the analysis.

• It should be performed by qualified and credentialed personnel. IRS auditors have made it clear that they regard 409A valuations in two categories: the valuations performed by knowledgeable, credentialed valuation specialists, and the rest. The IRS has signaled that as they review 409A valuations, they are prioritizing on the second category.

• It is essential that it be well documented, so that it supports the Board in its efforts to affirm to employees, auditors, and, ultimately, to the IRS compliance of the company’s option program.

• It should be prepared by a valuation firm able to stand behind the analysis, and to respond and defend the analysis to IRS and the company’s accounting auditors, perhaps years after it was prepared.

Factors for Considering a 409A Provider

Based on our extensive experience preparing and reviewing valuation opinions, we have listed below several of our recommendations for factors to consider when selecting a 409A valuation provider:

• First, does the firm have local professionals who work frequently with companies in your industry? This will not only enhance the depth and credibility of the analysis, but facilitate interaction between the provider and company so that a well-reasoned, thorough report is delivered in a timely manner.

• Second, does the firm have the knowledge and competency to get the result right in a way that is reasonable and defensible? This means performing a rigorous analysis and documenting how the valuation specialist reached the concluded value. It takes work and skill to get the right result that is neither “safely high” nor “insupportably low”.

• Finally, success in your business means your 409a valuations will be reviewed at some point in time – either when you sell the company or bring in auditors in anticipation of an IPO.  Even if you are OK with a poorly-prepared but “safely high” strategy, the days in which an auditor simply looks at a result, judges it safely high, and then gives the valuation a pass are disappearing. SEC and the PCAOB are requiring that auditors document their reviews of valuations, including showing the trail of specific questions, challenges, and responses in their workpapers. From the auditors’ standpoint, the valuation must be as reliable and well supported as all other information that is used in developing the audited financial statements.

Unfortunately, we do sometimes hear managements of early stage companies say their 409A valuations are a low priority, that they can skate by with their idea of minimum (which is not that of anyone at the IRS!). Their reasoning is that if the company is successful, then they will clean things up later.

Consequences of  Poor 409A Valuations

Problems arise when the company retains auditors, or is the subject of due diligence review prior to an M&A exit. Deficiencies with 409A reports can surface, and more importantly, will be documented in detail in the auditor’s workpapers. Auditor workpapers can be discovered by an IRS auditor or in litigation. It is imprudent to believe that skeletons will remain safely buried. Absence of a defensible opinion acceptable to peer review (whether in audit or M&A due diligence) frequently means the company is faced with more expense to redo the valuation in question (and often the need to cancel below market options or otherwise make whole the grantees). Listed below are some of the consequences:

• Grantee may effectively forfeit most of gain to tax and penalties
• Company may be liable for additional payroll taxes
• Company, directors, and management may be liable for suits brought by employee
• Delays in executing strategic transactions (due diligence failure)
• Expense of IRS, legal, audit reviews/defense
• Expense of redoing the valuation

Art v. Science in 409A Valuations

Valuation by nature is always contestable. It is often said that valuation is both an art and a science, and that means there will always be aspects of a valuation which require judgment and experience. But more importantly, it means that a valuation opinion must always be constructed in a way that is reasonable, well -upported, and defensible by a firm experienced, credentialed, and which will be around for many years after the valuation is delivered – ready, willing, and able to defend its work when challenged.

John is Executive Vice President, Valuations & Financial Advisory Services of The Brenner Group. John joined The Brenner Group® in 1994 and manages the firm’s Valuations and Financial Advisory Services Groups. John has more than thirty-five years of experience in corporate finance, and has assisted more than 600 companies with financing, public underwritings, mergers, acquisitions, and valuations. Prior to joining The Brenner Group, John held executive management positions at Smith Barney, The First National Bank of Chicago, and Price Waterhouse. He received an MBA in Finance from The Wharton School of Business, and a BA degree from the University of Pennsylvania. John is a candidate member of the American Society of Appraisers and a member of the Appraisal Issues Task Force.

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Valuations prepared to support stock option grants must comply with IRC Section 409A tax requirements and, if the company is subject to GAAP accounting, fair value rules found in ASC 718 (formerly SFAS 123R). These rules require the analyst to consider economic and industry conditions, as well as business fundamentals in the development of an estimate of value. Turbulence in economic and industry conditions must be considered as part of these analyses.

409A includes analysis of comparable companies

Often 409A valuations include a comparative analysis to the values observed for other companies in the relevant industry. Most management teams understand that valuation multiples related to revenue, earnings before interest, taxes, depreciation, and amortization (“EBITDA”) or other financial measures can fluctuate. They can fluctuate as stock market prices fluctuate. They can also fluctuate as industry analysts change their estimates of future growth and profitability of specific companies and industry segments.

During periods of economic turmoil, the results for a specific guideline company may change substantially due to specific issues (such as the loss/gain of a major customer) which may not be relevant to the company being valued, or others in the peer group. In these situations, the analyst must consider facts and circumstances of each selected guideline company to make sure adverse conditions at one company do not disproportionately impact the results of the study.

Valuation is influenced by market conditions

409A valuations also often include an estimate of value derived from projected future cash flows or earnings. Market conditions can influence these forecasts as well. These analyses apply a capitalization rate to projected financial results; the capitalization rate reflects estimates of the cost of debt and equity capital. These estimates of the costs of debt and equity capital are derived from prevailing interest rates and stock “beta” statistics, both of which are subject to fluctuation.

Beta measures the degree to which the change in the price of a security is correlated to changes in the equity market prices overall. A beta coefficient of 1.00 implies that a company’s return varies directly with the overall market. A beta of less than 1.00 implies the stock price tends to change to a lesser degree than the market, and a beta greater than 1.00 implies a stock price tends to change to a greater degree than the stock market.

Macro-economic and industry conditions are also reflected in the analysis. Generally, management includes in its financial projections demand estimates for the company’s products and services based on its assessment of the overall strength of the economy and demand for the goods and services in its specific industry, as well as the relative strengths and weaknesses of its offerings as compared to its competitors.

Valuations can be heavily influenced by external factors

Valuations for 409A compliance require consideration of factors internal to the company as well as external, such as market, industry, and general economic conditions. Turmoil in these external factors can be reflected in a number of assumptions in the valuation, including the comparative analysis of the subject company relative to its set of guideline companies, and economic data used to estimate the cost of equity and the cost of debt.

Far from being a theoretical exercise, external factors can significantly impact the value investors may place on an industry segment as well as the subject company itself. Under current volatile conditions, the impact on valuation results can be significant.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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Experience matters

In 1987, we were in a period when many of the younger investors had great educational credentials and could analyze how much to invest in a specific sector, but they lacked enough operational experience to understand what to do when the business was not succeeding. Many of the venture partnership funds were coming to the end of the lives of specific partnerships, and decisions on disposition needed to be made. If this sounds familiar, the same thing happened after the dot.com bubble broke, and again after 2008. Liquidity has become a big challenge even for successful companies, and thus many funds are again faced with critical decisions on how to gracefully exit companies that in good times could have had successful exits.

A memorable client

I remember one of our first clients, which was a little fair afield of technology businesses. We were called in to help a national RV dealership that had started the IPO process, only to find out they were almost out of business when the 1987 recession became a reality. They filed bankruptcy, and that is when we were called in by the debtor’s counsel. No one had been able to determine what the debtor’s financial status really was, as it appeared to be a moving target.

After analysis, we determined that the founder and his son had actually embezzled funds from the company. When I informed them they should not come back to the office, the son came back with an assault rifle to “take care of the guy who had fired him.” The federal Judge later said, “Mr. Brenner, I am not paying you enough for hazardous duty. Are you sure you can continue?” We did continue, and tried to find all of the money they had taken, which was in offshore bank accounts. This is clearly one of the most interesting memories over the past 25 years.

A difficult founder

Another interesting client was in the mid 1990′s, when we received a call on a Sunday from a large VC investor regarding a software company that the board thought was preparing for an IPO. The board had wanted to change CEO’s, but had to deal with a difficult founder. They had waited until the company needed a bridge loan to get to the IPO before telling the founder that the only way they would put more money in was for him to step aside as CEO, and serve as Chairman. We were asked to step in as interim CEO.

Once we got in, we found that the founder would try to undermine anything we tried to do, and that the company was far from any successful exit. The company had stuffed its customer pipeline full of product to the point that the distribution network had stopped paying for any inventory until it had sold through to their retail outlets. The average days sales outstanding in their accounts receivable was close to 200 days, and this was the reason they had run out of cash. When speaking with the customers in the channel, we found out the products just weren’t selling through to end customers. In the end, what was supposed to be an interim CEO position while the board looked for a CEO to take the company public, became an interim CEO position to salvage what we could, and sell the pieces of the business to interested buyers.

The last part of this story which is interesting is that the founder was needed when speaking with potential buyers of the software to explain the code, and the roadmap for the future. On the way to a major meeting with Microsoft, he informed the investment banker and me that no one would buy this piece of software because it was poorly written, and obsolete. But, he added, he could put a syndicate together to take it off our hands. At the end, one of the products was sold to a successful company for a reasonable amount, but the piece the founder wanted was sold to him for a very low sum, as he was never able to help us sell the technology.

A gratifying success story

I recall being called in to help a fabless semiconductor company. The company had been trying to develop too many different products, and had used about half of their available cash. The board decided that the company should focus on just one product, and one product only. We were asked to oversee the general operations and spending for the company. We immediately reduced their headcount by 80%, and brought their burn rate down from over $1 million per month to just over $150K per month. Then whenever someone wanted to spend money, we were the final say on whether it was necessary to complete the first product.

The first product was publically announced about 9 months after we started, and began shipping about 3 months later. Because of the low cash burn rate, the company was profitable within 4 months of shipping the first parts, and went public on NASDAQ 12 months later. When our assignment ended, the board passed a resolution stating The Brenner Group had single-handedly saved the company, and gave us a very nice bonus of shares in the public company. Clearly, this was a shining moment for our firm in our history.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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In this post, we will discuss the definition of a qualified appraiser.

A qualified appraiser is an individual who meets all the following requirements:

1. the individual either:

a. has earned an appraisal designation from a recognized professional appraisal organization for demonstrated competency in valuing the type of property being appraised, or

b. has met certain minimum education and experience requirements. For real property, the appraiser must be licensed or certified for the type of property being appraised in the state in which the property is located. For property other than real property, the appraiser must have successfully completed college or professional-level coursework relevant to the property being valued, must have at least 2 years of experience in the trade or business of buying, selling, or valuing the type of property being valued, and must fully describe in the appraisal his or her qualifying education and experience;

2. the individual regularly prepares appraisals for which he or she is paid;

3. the individual demonstrates verifiable education and experience in valuing the type of property being appraised. To do this, the appraiser can make a declaration in the appraisal that, because of his or her background, experience, education, and membership in professional associations, he or she is qualified to make appraisals of the type of property being valued;

4. the individual has not been prohibited from practicing before the IRS under section 330(c) of title 31 of the United States Code at any time during the 3-year period ending on the date of the appraisal; and

5. the individual is not an excluded individual.

In addition, the appraiser must complete Form 8283, Section B, part III. More than one appraiser may appraise the property, provided that each complies with the requirements, including signing the qualified appraisal and Form 8283, Section B, Part III.

Who is an excluded individual?

The IRS excludes several individuals from being a qualified appraiser that may have a direct or indirect conflict of interest.

Specifically, the following persons cannot be qualified appraisers with respect to particular property:

1. the donor of the property, or the taxpayer who claims the deduction;

2. the donee of the property;

3. a party to the transaction in which the donor acquired the property being appraised, unless the property is donated within 2 months of the date of acquisition and its appraised value is not more than its acquisition price. This applies to the person who sold, exchanged, or gave the property to the donor, or any person who acted as an agent for the transferor or donor in the transaction;

4. any person employed by any of the above persons. For example, if the donor acquired a painting from an art dealer, neither the dealer nor persons employed by the dealer can be qualified appraisers for that painting;

5. any person related under section 267(b) of the Internal Revenue Code to any of the above persons or married to a person related under section 267(b) to any of the above persons (i.e., family members, fiduciaries and beneficiaries of a trust); and

6. an appraiser who appraises regularly for a person in (1), (2) or (3), and who does not perform a majority of his or her appraisals made during his or her tax year for other persons.

In addition, according to the IRS guidance, a person is not a qualified appraiser for a particular donation if the donor had knowledge of facts that would cause a reasonable person to expect the appraiser to falsely overstate the value of the donated property. For example, if the donor and the appraiser make an agreement concerning the amount at which the property will be valued, and the donor knows that amount is more than the fair market value of the property, the appraiser is not a qualified appraiser for the donation.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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1. What is a Qualified Appraisal?

A qualified appraisal is an appraisal document that:

- is made, signed, and dated by a qualified appraiser in accordance with generally accepted appraisal standards;

- meets the relevant requirements of Regulations section 1.170A-13(c)(3) and Notice 2006-96, 2006-46 I.R.B. 902 (available at www.irs.gov/irb/2006-46_IRB/ar13.html);

- relates to an appraisal made not earlier than 60 days before the date of contribution of the appraised property;

- does not involve a prohibited appraisal fee; and

- includes certain information.

The qualified appraisal must be received before the due date, including extensions, of the return on which a charitable contribution deduction is first claimed for the donated property. If the deduction is first claimed on an amended return, the qualified appraisal must be received before the date on which the amended return is filed.

2. What is a prohibited appraisal fee?

Generally, no part of the fee arrangement for a qualified appraisal can be based on a percentage of the appraised value of the property. If a fee arrangement is based on what is allowed as a deduction after Internal Revenue Service examination or otherwise, it is treated as a fee based on a percentage of appraised value, rendering disqualification of the appraisal.

3. Information included in qualified appraisal:

A qualified appraisal must include the following information:

1. a description of the property in sufficient detail for a person who is not generally familiar with the type of property to determine that the property appraised is the property that was (or will be) contributed;

2. the physical condition of any tangible property;

3. the date (or expected date) of contribution;

4. the terms of any agreement or understanding entered into (or expected to be entered into) by or on behalf of the donor that relates to the use, sale, or other disposition of the donated property, including for example, the terms of any agreement or understanding that:

a. temporarily or permanently restricts a donee’ s right to use or dispose of the donated property,

b. earmarks donated property for a particular use, or

c. reserves to, or confers upon, anyone (other than a donee organization or an organization participating with a donee organization in cooperative fundraising) any right to the income from the donated property or to the possession of the property, including the right to vote donated securities, to acquire the property by purchase or otherwise, or to designate the person having the income, possession, or right to acquire the property;

5. the name, address, and taxpayer identification number of the qualified appraiser and, if the appraiser is a partner, an employee, or an independent contractor engaged by a person other than the donor, the name, address, and taxpayer identification number of the partnership or the person who employs or engages the appraiser;

6. the qualifications of the qualified appraiser who signs the appraisal, including the appraiser’s background, experience, education, and any membership in professional appraisal associations;

7. a statement that the appraisal was prepared for income tax purposes;

8. the date (or dates) on which the property was valued;

9. the appraised fair market value on the date (or expected date) of contribution;

10. the method of valuation used to determine fair market value, such as the income approach, the comparable sales or market data approach, or the replacement cost less depreciation approach; and

11. the specific basis for the valuation, such as any specific comparable sales transaction.

The Pension Protection Act also adds the notion of a qualified appraiser. We will discuss the necessary qualifications in the next blog post on “What is a Qualified Appraiser?”.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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J. Weston (Wes) Rose is Senior Vice president of The Brenner Group, one of Silicon Valley’s premier professional services firms. Wes has enjoyed an extensive career as a C-level operating executive with multiple venture capital backed technology companies and now runs the firm’s interim management and restructuring practices.

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