Common stock valuations (a.k.a. 409A valuations) are often viewed by companies as necessary evil or insurance policies for an unlikely event of IRS audit. While no signs of IRS scrutiny emerged, 409A valuations play increasingly important role in start-up financial management.
- Financial Audits: Few companies can attract sizable investors without having to produce audited financial statements. As early as Series A, companies settle with brand-name audit firms and become responsible for reporting their stock-based compensation expense with 409A valuation providing key inputs. Poorly done valuations are rejected or revised, even after stock options have already been granted.
- M&A Due Diligence: Your potential acquirer is likely to conduct financial due diligence prior to making the acquisition. Common stock valuations are thoroughly reviewed and challenged. Questionable valuations will give your acquirer an opportunity to negotiate lower purchase price or indemnifications or outright reject certain stock option grants.
- Second Market Transactions: No 409A report should be used directly in pricing second market transactions. Still, companies tend to utilize 409A valuations as a guide. Management often finds themselves scrutinizing 409A a lot more than the initial compliance driven purpose of the valuation exercise would suggest.
- Pricing Strategic Transactions: A share of common stock is less valuable than a share of preferred, sometimes by a significant amount. Yet, we see many transactions (M&A, second market, strategic) where common stock is assigned the same value as preferred. The results of such simplification can be devastating. There are issues with immediate tax liability exposure as well. 409A valuations can provide guidance and your valuation specialist should be able to do simple ad-hoc calculations when needed.
- Law Suites: Latest attempt by Winklevoss twins to re-negotiate their settlement with Facebook was based on 409A valuation they uncovered too little too late (http://lnkd.in/b3rrqBV). We hear of many disgruntled employees unhappy with stock options and investors frustrated with supper-low option exercise prices that dilute their investments. The quality of the valuation analysis can be an effective defense in avoiding lawsuits.
- Strategic Planning: Company valuation is the ultimate measure of entrepreneurial success. It is the key to guiding executive teams through the mambo-jumbo of marketing strategies, product roadmaps, and SWOT analyses. Larger companies invest in strategic planning departments. Smaller companies are often in the dark. A meaningful 409A analysis may be your only conclusive evidence as to how well the company performed in the last twelve months.
- Universal Equalizer: Many stakeholders with conflicting economic goals rely on common stock valuations. While employees hope for lower option exercise prices, investors don’t want to suffer from excessive dilution. Management needs documents supporting (or at least not conflicting with) higher valuation when negotiating with investors or acquirers. At the same time, companies hope to pay as little as possible repurchasing shares. The set of issues is so complex that the best approach is to commission a high quality valuation in order to establish a fair playing field for all parties involved.
