Not All Valuations Experts Are Created Equal

Private technology companies are required by the IRS (Code Section 409A) to grant their common stock options at a strike price that is not less than the fair market value of common stock. The IR Code recommends that a valuation of common stock be done not less than annually, if not more often.

It’s very important that your valuation expert has experience doing the type of valuation you need for the “audience” the valuation is intended for. Who, other than senior management at the Company, will be examining the valuation? Let’s take a look at the different audiences that may be reviewing the 409A valuations and the depth of knowledge you should look for and key question to ask before selecting your third party valuations expert.

409A Valuation: Early Stage Companies

The Company’s Board and the IRS are the two parties that these valuations are intended for. Does your valuation firm regularly do valuations that are examined by the Board of early stage companies? If they do lots of 409A valuations then they probably do, and they will understand what the Board will expect to see. If they have been doing valuations for less than five years or if the people doing the valuation don’t do it full time (that is, they do valuations outside of tax season) they may not be aware of recent developments in valuations, especially tech or biotech company valuations. It's a good idea to hire a valuation expert that has experience having their valuations reviewed by the IRS. Valuation experts that do valuations for estate & gift tax purposes in addition to 409A valuations will have had their valuations scrutinized by the IRS.

409A Valuation: Later Stage Companies and Purchase Price Allocation (PPA) Valuations

In addition to the Company’s Board and the IRS, 409A valuations for later stage companies will very likely be reviewed by the Company’s auditor. PPA valuations will be reviewed by the auditor. Audit firms are held to a high standard, and their reviews of valuations reflect this. Additionally, the valuation will be reviewed both by the audit team and by valuation experts at the audit firm. I recently heard a high ranking valuation Partner from a prominent audit firm talking about problems he sees when reviewing valuations, and one of the areas was that the valuation did not take into account recent accounting literature.

Yes, accounting literature. Since I started doing valuations 19 years ago, more and more valuations are being done for financial reporting purposes. This means that a good valuation expert needs to be current on the latest accounting pronouncements that impact valuations. Valuation experts that do 409A and purchase price allocation valuations that work at a strong audit firm benefit from the knowledge of the auditors in their firm. Being able to walk down the hall and talk to an Audit Partner on how the latest FASB pronouncement impacts valuation is a major benefit for a valuation expert that works for a CPA firm.

409A Valuation for Companies on the IPO Track

In addition to the parties mentioned above, the SEC will also be scrutinizing these valuations. The SEC intensively reviews and scrutinizes a Company’s S-1 and one of the areas they review is the Company’s common stock (409A) valuations. The SEC will expect certain, more advanced valuation methods to have been used on valuations that are performed close to the time of a Company’s IPO, so it is important to have a valuation expert that has done work for companies that have submitted a filing at the SEC to go public and have achieved an IPO.

Choosing a third party valuations expert with appropriate experience, who understands the different reviewing audiences is vital to getting through a review without complications. When selecting a third party to conduct valuations, consider asking the following key questions:

• How many years of experience do you and your team members have? Appraisers with more years of experience are naturally exposed to different issues and would be more adept in handling a diverse set of valuation issues.
• Do you have valuation-related credentials? Credibility is quite important in business valuation since some practitioners do not have the expertise or credentials needed to perform valuations competently.
• Have you valued companies in my industry or a closely-related industry? It is important that your valuation expert knows, understands, and can defend the chosen valuation methodologies that are commonly accepted for your industry
• Who will be working on my valuation? Stand-alone valuation boutiques lack the resource of a pool of expertise and may lack the flexibility for a fast turnaround time.
• What is your experience with our auditors and the SEC (Company on the IPO Track)? Having a valuation firm that has had their valuations scrutinized by the SEC is a good idea, since common stock values is one of the issues the SEC has been focusing on in their reviews of S-1
• Have any of your reports been submitted to the IRS? Having a valuations experts with a track record of valuations routinely accepted by the IRS is a good indication of the work quality of the appraisers.

Not All Valuations Are Created Equal

An experienced valuation expert should be able to prepare a valuation which will pass an audit without complications while also complying with the applicable tax regulations and standards. Other important factors to consider when selecting a valuations expert can be found in the How to Guide: Walking Your Board through a 409A Valuation of Total Equity white paper.

April 18, 2019