409A valuations are a pain. We have spent nearly a decade making equity compliance easier for CFOs. In February 2016, we hosted our first Capshare (now Shareworks Startup Edition) Valuation Summit here in the beautiful Rocky Mountains.
The event brings together the country’s highest-volume 409A valuation firms to improve services for our clients. This year, we created a better 409A valuation method for early-stage companies that have raised money using a convertible security. “Convertible securities” include convertible debt, SAFE, or KISS securities.
A lot of our clients use these securities. Unfortunately, we have seen an increase 409A valuation issues involving these securities too. So we got some of the smartest people in the industry together to find a better way. Please forgive the self-serving compliment!
409A Valuation Basics
Before jumping in, let’s go over the basics of 409A. IRC 409A is an IRS requirement. It applies whenever you issue deferred compensation to your employees. Deferred compensation includes stock options. To comply, you have to set the strike price of your stock options equal to the fair market value of common stock.
Many CFOs understand accounting, finance, and some valuation. But most can’t create IRS-compliant valuations. Picture some person acting as an expert witness in a trial testifying about how to value intellectual property. Those are the people who perform 409A valuations. We have written a lot about 409A valuations and have even published a definitive guide for CFOs (it’s free).
If you don’t comply with 409A, there are some nasty consequences. So let’s just say you want to comply!
Why Complying with 409A Is Important for CFOs
Most CFOs get involved in the 409A valuation process in only a few ways:
- Selecting the valuation service provider
- Reviewing a draft of the report
- Circulating the report to the company’s board of directors
- Handling any “push back” from auditors
Most of these steps are easy. Check out our guide if you want more details on all of the steps.
However, a lot of startup CFOs struggle to handle auditor “push back”. What does this look like? Well typically you will get a letter like this from your auditor:
If you get a letter like this, it doesn’t mean you are in deep trouble! Your audit firm is just doing it’s job. Auditors just need to audit your valuation assumptions.
Most of the time, your valuation firm can answer these questions easily. Valuation firms expect these questions. And they typically won’t charge you more to answer them.
Costs (and Hidden Costs) of 409A Valuations for CFOs
But it -can- get a lot worse. Why? If the audit firm can’t get good answers to these kinds of questions, they get worried. Then they ask for even more justification. This can happen because your 1) valuation firm didn’t do a good job or 2) your audit firm is pushing too hard. For example, a lack of a standard approach could create this problem.
If your auditor digs in deeper, they will charge you for the extra work. They may even ask you to get another valuation. While rare, this is a really bad outcome for you. You may have to pay another valuation firm to re-do the work. You might even have to re-issue any options that used the wrong strike price.
Re-issuing options is a huge mess. It often involves legal fees, upset employees, accounting costs, and a lot of time. Sometimes you will even need to give employees additional monetary remuneration or new options.
So CFOs should be smart when selecting a valuation partner. But sometimes this situation isn’t completely the valuation firm’s fault. Sometimes auditors take issue the method your firm used even when there are no better methods out there.
For example, there are no standards for these kinds of really common 409A valuations:
- 409A valuations involving convertible securities
- 409A valuations of the earliest-stage companies
We hosted this year’s valuation summit to try to create standard methods for these situations.
Convertible Security 409A Valuations
Performing a valuation for a brand new startup is daunting. Most of these companies have little or no revenue, limited traction, and poor records.
When a company raises money using stock, it will set a share price. Valuation providers use this information as a basis for their valuations. When a company raises money using a convertible security, it doesn’t set a share price. Convertible securities allow companies to raise money from investors without agreeing on a current valuation. So valuation firms don’t have much information to go on in these situations.
Until now, valuation service providers performed these valuations with unreliable information and standards. Worse, auditors often disagreed with the approach a firm uses. When this happened, it could lead to increased costs for the company.
Most of us just want to roll our eyes at the IRS for making early-stage companies comply this way. Who knows what a company is worth in its earliest stages, right? Unfortunately, unless the IRS changes its rules, you will need to comply. This means figuring out the best way to perform these valuations.
Our White Paper
This is the problem we addressed at our valuation summit. We wrote a white paper that proposes two better methods for these valuations. Your 409A firm can use this paper to help decrease your audit costs. The paper is technical but if you want to get your inner valuation geek on, go ahead and check it out.
If you just want the highlights, keep reading. You will learn quite a bit about 409A valuation methods as we go.
To decrease costs, a good valuation method should be easy and defensible.
What does “defensible” mean? Defensible means it will stand up to auditor scrutiny.
So we looked for easy, defensible valuation methods. We found two approaches we liked best.
A Primer on Valuation Methods
Before getting into the conclusions of our white paper, let’s understand the basics of valuation first. Valuation analysts can usually use one of three methods. The three methods are:
- An income approach
- A asset approach
- A market approach
The income approach says a company is worth the net present value of its income. Analysts usually perform a discounted cash flow for this approach.
The asset approach says a company is worth the value of its assets. There are a few ways to find the value of a company’s assets. Most involve just using the cost paid for the assets.
The market approach says a company is worth whatever a buyer would pay for it. There are two important market methods: “comps” and the Backsolve OPM.
Let’s discuss each further as it relates to early-stage companies with convertible securities.
Income Approaches (DCFs)
The most common income approach is a discounted cash flow (DCF). DCFs work best when an analyst can accurately forecast financials. This is not true for early-stage companies. So we determined that this method is not ideal.
There are two big kinds of market approaches:
- “Comps” approaches
- Backsolve OPM
Most companies aren’t in the middle of being bought. So analysts estimate a company’s market value based on the price of a similar company. The similar company is called a “comparable” (or “comp” for short). Doing this is called a market “comps” approach.
If you have ever bought or sold a house, you probably have seen something similar. Your realtor estimates the value of a house by finding other similar homes’ prices.
The realtor will probably make some really important adjustments though. Let’s say she finds a really similar comp home but your home is 20% smaller. To correct for that she will find the other house’s price per square foot. She will then multiply that price by your house’s square feet.
Valuation analysts do something similar for companies. Unlike homes, private companies often do not tell anybody the price they sell at. They keep it private. To perform a comps analysis, we need to know a company’s selling price.
Public companies have to publish their price every day on the stock market. So analysts will often use public companies as comps for private companies. They also use other private companies when the price is available.
In valuation reports, analysts call these kinds of comps methods “guideline” approaches. Comps approaches rely on financial data like revenue. Many early-stage companies little or no revenue. So we determined this approach is not ideal.
A Backsolve OPM uses the price that an investor paid for part of a company to estimate the value of the whole company. Analysts frequently use the this method because it is easy and defensible. Many analysts feel it is one of the most objective methods because it uses directly relevant price info.
This method usually relies on knowing the price of the company’s most recent stock. What if the most recent stock is a convertible security? Then we have problems. Convertible securities do not have a price. So the traditional Backsolve OPM does not work.
It is possible to estimate a range of prices and assign them probabilities. This is an educated guess. If you do this, then you can use a Backsolve OPM. We created a new approach that does this. We call it a Probability Weighted Backsolve OPM.
Most experts frown on using the cost approach unless a company is dying. Experts view the cost approach as a low-end estimate of a company’s value. The idea is that a company is worth more than the sum of its assets.
But we found that many experts feel there is an important exception. If there are no other reliable approaches, you can use the cost approach.
After reviewing various cost approaches, we recommended two specific cost approaches that could work well.
We also looked at how different valuation approaches affected strike prices. You can see our analysis below.
If you want to read the whole paper, we have included it here. Just click on the image below: