Common Pitfalls to Avoid in a 409A Valuation

How to Avoid Them!

A 409A valuation refers to a method of determining the value of a company’s common stock. In other words, the 409A valuation is a method of calculating fair market value (FMV) according to the regulations under the Internal Revenue Code (IRC). This valuation can be carried out using various types of valuation methodologies, however, it is important to avoid pitfalls in 409A valuation when carrying out the valuation to obtain a more accurate result. In this article, we will discuss some of the most common mistakes that can be made when carrying out a 409A valuation, as well as how to avoid them.

A 409A valuation refers to a method of determining the value of a company’s common stock. In other words, the 409A valuation is a method of calculating fair market value (FMV) according to the regulations under the Internal Revenue Code (IRC). This valuation can be carried out using various types of valuation methodologies, however, it is important to avoid pitfalls in a 409A valuation when carrying out the valuation to obtain a more accurate result. In this article, we will discuss some of the most common mistakes that can be made when carrying out a 409A valuation, as well as how to avoid them.

409A Valuation and its Pitfalls

Enron’s employees lost billions in pension payouts and 60% of their 401(k) assets when the company’s stock crashed. The IRS executed tax code IRC 409A in 2005 in response to the Enron crisis, and after the enactment of the American Jobs Creation Act of 2004. This law subsidized equity loopholes when employees are given stock. Also, the main purpose of setting up this valuation is to determine the company’s share price for officers, directors, and other key employees in regard to the Employee Stock Ownership Plan (ESOP), Employee Stock Option, or Share-Based Compensation plans. According to the rules and regulations of 409A, the common stock must be appraised every year.

In essence, the amount required to purchase a company’s stock (fair market value) is determined according to this valuation. This valuation is most used when selling a company’s stock or when issuing and offering new stock for the first time.

It is crucial to ensure that this valuation is carried out properly, avoiding the common pitfalls that can occur during the procedure. Thus, pitfalls in 409A valuation can result in a loss of valuable time and resources and have a negative impact on the company’s financial records.

Understand 409A Valuation: Why is it Important to Perform?

This valuation is a financial instrument that can be used to determine the FMV of a company’s equity. Since this valuation is used to determine what its FMV is, it is a financial tool that can be used by company officials when issuing shares of stock or selling their equity. Following are some of the importance of 409A valuation:

• This valuation is used to ensure that the company’s financial records are in line with the IRS regulations. In other words, any company transactions must be reported and reflected in their financial statements.
• This valuation is used to ensure that all the company’s financial records are accurate and reflect the true value of the stock. Thus, following a proper 409A valuation procedure will lead to a more accurate valuation.
• This valuation procedure is used to ensure that the company complies with the IRC rules and regulations. If a company fails to comply, it could result in penalties, fines, and other sanctions.

How a 409A Valuation Differs from Standard Valuation

A 409A valuation’s focus is not to analyze the company’s value but, instead, to determine the FMV of the shares. In fact, the 409A valuation is used when determining the “purchase price” or “market price” at which they will purchase stock. As shown below, the 409A valuation procedure differs from a standard valuation in several aspects:

• A 409A valuation often involves a more formal and structured process of examination. While a standard valuation is usually based on calculations and valuations, sometimes carried out more informally by accounting departments.
• A 409A valuation is mandatory when issuing or offering new stock, while a standard valuation is usually required when it comes to the company’s intention for investment, securing loans, or selling the company.
• 409A valuation firms specialize in specific calculations for complex equity structures, such as the backsolve approach, waterfall analysis, and option pricing models to determine FMV of different security classes, whereas standard valuation firms specialize in income approach, market approach and asset-based approaches.

What are the Common Pitfalls in 409A Valuation while Issuing Equity?

To ensure that this valuation is carried out correctly, it is important to be aware of the common pitfalls that can occur during the procedure. Failure to understand these pitfalls could lead to a negative impact on the company’s financial records. Here are some of the most common pitfalls that should be avoided during a 409A valuation:

• Unnecessary step to get the lowest strike price: To obtain the lowest strike price possible, it is common for companies to carry out unwanted techniques to reduce their strike price. This is because it is well known that the strike price will directly impact the cost of equity and taxes owed. And since this valuation focuses on determining the purchase price at which they will purchase stock, they tend to focus on obtaining a low strike price. While this could result in companies reducing their FMV significantly, there are onerous penalties imposed by the IRC for any grossly unreasonably low FMV on the company’s shares.
• Negatively affecting the acquisition or initial public offering (IPO): The FMV of the company’s stock is an important factor when valuing a company during an acquisition or IPO, as it determines the back taxes for the employee’s options. Thus, if a 409A valuation report is not carried out properly and accurately, it could negatively affect the results of an acquisition or IPO on the company’s staff.
• Unqualified appraisers are hired: Hiring an appraiser to carry out a 409A valuation could affect the quality of the report as well as the company’s records. In order to ensure that the report will be accurate and reflect the true value of a company’s stock, it is important to hire a qualified and experienced appraiser who would conduct a fair evaluation of the stock.
• Violate 409A compliance regulation: Failure to comply with the 409A compliance regulation could lead to severe financial penalties, fines, and other sanctions. To ensure that a company is fully compliant with the IRS rules, it is important to work with a professional and experienced appraiser who will provide the company with a report that the IRS thoroughly reviews.

Valuation Methods

There are several different methods used to value a company’s stock in order to determine its FMV. It is important to remember that the choice of method will depend on the context in which it is being used. Following are some of the most common methods used in 409A valuations.

• Income approach: The income approach is used to determine a company’s FMV based on future cash flows. This is usually performed by taking the company’s forecasted income, which is discounted back to today’s value using the company’s weighted average cost of capital. This method is generally carried out for companies that are expected to generate positive cash flows in the future. The income approach is also known as discounted cash flow (DCF).
• Market approach: The market approach is used to determine FMV using the company’s comparable peers. In other words, a company’s valuation is determined by comparing similar companies with similar business characteristics and financial performance. The valuator then uses its financial data to develop forecasts and ultimately determines the FMV of the company’s stock. This method is usually used by companies looking to determine the value of a potential acquisition.
• Asset-based approach: The asset approach is used to determine a company’s FMV based on its assets, liabilities, and other intangible assets. The asset approach is generally used when valuing the company’s stock in the acquisition or potential merger. This method starts with the number of assets the company has, then identifies its liabilities, and, finally, determines the value of its assets and intangible assets. The result is a FMV of a company’s stock.

How to Avoid Using the Wrong Approach

To avoid this pitfall, it is advised to have a thorough review of the company’s financials to identify any errors and highlight any problems that may occur during the valuation process. Using the wrong valuation method would conclude a firm value drastically different from what a willing buyer would pay.

Some firms may use a general market approach when an asset-based approach is more suitable, especially for tech firms still in the early stages of development. Common among 409A valuations are a company’s conducting round of funding, where a backsolve method (discussed later) is more appropriate. So it is important to analyze what method accurately represents the true value of the firm.

Valuation Multiples

In the valuation of a company, one thing that must be considered is the multiple that is used to value its stock. The purpose of valuation multiples is to facilitate the process of comparing a company’s stock with the stock of its peers and competitors. The following is the common valuation multiple that is used in 409A valuations.

• Percentiles vs. median/average: The vast majority of 409A valuations use financial ratio analysis, which is based on a company’s financials, among other factors. This refers to the percentage of companies in the same industry and region as those valued with a lower valuation. On the other hand, the median or average is based on the middle value of the company’s peer group. This is calculated by determining the “middle” number of each company in a certain parameter using the same data. It is important to understand that while both these valuations provide a valuation based on the same metric, the percentile ratios will be affected by outliers.
• How to avoid this pitfall: When working with any of the valuation multiples, it is important to carefully consider the business case for a certain valuation, particularly when it may be different from the company’s peers or the industry average.

While the standard approach is to apply a median or average multiple, many of these companies have factors such as their size, profitability, growth, and financial ratio analysis which may warrant a 25^th percentile or other multiple to be used.

The best way to determine which multiple is the most appropriate is to compare the results of each multiple and review the qualitative comments that will help explain differences in value.

Backsolve Method

The backsolve method refers to the method used by evaluators to determine a company’s fair value of common shares of organizations with complex capital structures. This method works on the principle of the option pricing model (OPM), which essentially breaks down a hypothetical acquisition of the company into tranches and gives a value to each using an OPM. It is essential that all the parameters of the company’s stock are included in this calculation. As a result, the backsolve method is often used to come up with a fair value and presents an alternative to the 409A valuation process.

• Arm’s length transactions: It states that transactions should be valued the way they had been carried out between unrelated parties, each acting in his own best interest. In practice, it means that the transaction price must be close to the price that would have been reached had unrelated parties been negotiating under comparable circumstances, each with a reasonably accurate knowledge of relevant facts, and each acting to maximize their own interests.

As in the case of some share transactions, the parties are known and the transaction does not represent an arm’s length transaction. Thus, it is not representative of FMV. For these types of deals, the backsolve method should not be implemented.

• How to avoid this pitfall: One of the best ways to avoid this pitfall is to conduct an arm’s length transaction, which involves developing a detailed analysis and understanding of the transaction in question. It is important to clearly understand each party’s objectives and how they are relevant to the valuation.
• Stock option pitfalls: The stock option pitfalls can lead to an inaccurate 409A valuation report, which will result in the failure to accurately model the value of an employee’s stock options. The common pitfall is using incorrect assumptions or incorrect formulas, which will inevitably result in an error-ridden report. As a result, there is an increased risk of the IRS rejecting the report for stock options calculation. It is important to avoid these common pitfalls and use the correct formula and assumptions to calculate the 409A valuation.
• How to avoid this pitfall: It is imperative to carefully research and verify each and every fact in the calculation of the strike price. As a result, you should keep all the relevant facts updated in a valuation report so that any changes can be taken into consideration by the IRS when reviewing the report.

Waterfall Analysis and Option Pricing Models

The waterfall analysis is the process of measuring the total value of the company among the various shareholders upon exit of the organization. While the open pricing model provides an evaluation of each of the company’s securities, especially for complex capital structures. As a result, the valuation of options has become a more accurate and effective process since firms have begun to rely more heavily on these models.

• Sensitivity of inputs: exit year and volatility: The pitfall in the sensitivity of inputs is associated with the possibility of undervaluing or overvaluing an organization’s stock. This results from bad assumptions that are used in the valuation and can be fatal in the eyes of the IRS. Waterfall analysis and option pricing models are based on exit year and volatility inputs, which affect the way the stock options are valued. As a result, care must be taken when determining these values to make sure that assumptions are accurate and that the 409A valuation is correct.
• How to avoid this pitfall: To avoid this pitfall, it is important that each input into the valuation is carefully reviewed and verified before being used in the calculation of your 409A valuation report. It is essential to make sure you are using the best assumptions and that they are consistent with the company’s financial position and overall strategy.

Conclusion

A 409A valuation is an important process for determining the value of a company’s stock options. An accurate valuation will result in fair and competitive option compensation for employees. Inaccurate estimations of value could have severe consequences, which can affect the value and competitiveness of a company’s stock options. As a result, it is important to understand each of the pitfalls to avoid them so as to ensure an accurate 409A valuation.

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Colin McCrea, CVA, is head of the valuation team at Eqvista. He has years of experience in the taxation and auditing sector for small and medium sized companies in the U.S. and Asia. He is currently managing company valuations and corporate taxation, and has worked on acquiring IncParadise and setting up a CPA firm.

Mr. McCrea can be contacted at (702) 751-6738 or by e-mail to colin@eqvista.com.