You’re Fired: the Hidden Costs of Botched 409A Valuation Compliance – Part II
In Part I of this series, we explained why you can’t judge a valuation or a firm by its fees . Coming into focus now should be an understanding of how a poorly prepared valuation turns into a time and cost debacle as valuators battle and hourly billing charges escalate. Let’s put some hard numbers on the assumptions. For our analysis, we’ll assume an early stage high tech company that has not yet engaged financial auditors. In our simplistic example, the buyer cannot distinguish quality and is left to rely on quoted fees as the basis for the engagement. After bargaining with three or four valuation firms, the winning bid (perhaps a sole practitioner in between jobs) comes in at a fraction of the high bidder.
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:
|Valuation firm fee to defend opinion||$10,000||$ *|
|Accounting firm fee to review opinion||25,000||*|
|Incremental management time||2,500||*|
|Total costs before fees for new opinion||37,500||*|
|Base fee for new opinion||15,000||0|
|Valuation firm fee to defend new opinion||*||0|
|Accounting firm fee to review new opinion||*||0|
|Total costs after fees for new opinion||$ 52,500||$ *|
|* Probably some review costs but nominal in amount.|
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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