What Makes a Good 409A Valuation
It may sound like common sense, but a 409A valuation needs to satisfy certain minimum requirements:
- 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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