Managing Financial Projections for 409A Valuations

March 4, 2009 at 4:04 pm

As an early stage technology company grows and matures, the finance and accounting functions should be expected to grow and mature along with it. From the perspective of 409A and 123R compliance, this means that over time there should be improvement in the financial projections maintained by the company. There should also be a routine process for producing and refining projections. An important motivator for improved projections is defensive. Increasingly, once a company has become successful and brought in auditors in order to begin preparations for an ultimate exit (whether IPO or acquisition by another company), the auditors may perform some historical testing of the basis of the company’s earlier 409A and 123R analyses. Typically, the auditors will ask whether financial projections they see in a valuation study correspond to financial projections provided to the board of directors or to investors. If the projections are different they will want to know why.

The easiest answer in this case is for the projections to be the same. The next best thing is a high level of consistency and continuity among projections. The company should have a “master set” of projections adopted by the board as the official plan of the business and which is also used for tax and accounting compliance.

Maintain Continuity and Establish a Process
Unfortunately, the easiest answer is not often the feasible answer. The typical early stage technology company undergoes change at breath-taking speed, frequently making rapid and significant changes to its product, marketing, and sales strategies, as well as sourcing and operational capabilities. The current period of economic turmoil has exacerbated this situation placing financial and cash flow constraints upon many companies. The result: companies may explore and evaluate a broad set of alternative plans, budgets, and financial scenarios on a continuous basis. Not every version will be formally presented to the board or to investors. The projections used for valuation purposes may be very different than the last set of projections presented to the board.

One solution is to create and maintain financial projections in a two-phased process. In the first phase, management memorializes its current expectations for revenues, expenses, compensation, and all other key elements that make up its financial plan and prepares an official version of the company’s financial projections. In the second phase, these projections are presented to the executive management and to the board and are used as a key input to the 409A valuation study. Of course, the valuation specialist may still choose to adjust (or “normalize”) the results as part of the 409A valuation study. However, the audit trail is now clear and will be traceable by all, including that skeptical auditor.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst designation and is a member of the CFA Institute and the CFA Society of San Francisco.


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