You’re Fired: the Hidden Costs of Botched 409A Valuation Compliance – Part I
When was the last time you bought a service you understood little about and, for lack of any other reason, selected the vendor based on price? Happens all the time with electricians, lawyers, mortgage brokers, auto repair shops, and tax preparers. And the consequences can be immense as the incompetent prey on the ignorant, often delivering little if any value for their fees.
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.
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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