What Is Your Stock Worth?

I just did a rather lengthy post on the newly minted Seattle 2.0 site about 409a valuations.  I am re-posting it on the Whisperer.  I am super excited to be a regular contributor and thanks to Marcelo and Alyssa for driving it.  Seattle needs more resources like this to better support our entrepreneurial spirit in this region.  Now for the meat.....

Most certainly you’ve heard about the IRS Regulation 409A.  Here is some "light" reading on the subject from the IRS in case you are interested.  It became effective on January 1, 2005 by the IRS and came out of all of the nasty Enron mess.  What is it?  It has to do with the treatment of non-qualified deferred compensation.  Many of your investors are typically concerned about this issue.  In a nutshell, this is a broad regulation for private companies and it redefines the way companies determine fair market value in granting stock options. In the past, what would typically happen is that your Board would make what is a called a good faith determination of fair market value and grant options. Now, companies must formally value their common stock options or risk the penalties should they be wrong with their option pricing. I would also like to not that I am not a financial professional (but, only play one on the blogosphere). 

So why do you care?  Well, the main reason is that if you are not valuing your options appropriately, penalty for undervaluing options is that the option holder gets taxed at normal income rates on the “spread” (difference between the grant strike price and what the IRS deems the “correct” value) as if it was income given to him by the company PLUS an additional 20% tax on top of this in further penalties. Furthermore, the company gets penalized on withholdings it should have made on this additional “compensation” it provided to the employee. According to the IRS, under 409A, there are three choices to value stock options as a private equity stage company:

1. The Board determines in good faith the FMV, but if an option holder gets audited and the IRS thinks the strike price is not truly FMV, then the option holder has burden of proof to show otherwise;
2. Have a person, internal to the company who has “significant knowledge and experience or training in performing similar valuations”; create a written valuation report detailing the accurate pricing of the common stock.  The IRS does not provide an explanation of the parameters for “significant knowledge and experience or training in performing similar valuations. The big issue is no one really knows who qualifies to do the valuation and what the report should look like.
   

3. Hire an independent, qualified, experienced valuation firm to create a written valuation report.  This is still not clear, as outside of the traditional valuation firms, it’s unclear who is qualified to perform the valuation.

There is a lot more around this subject.  When the regulation was first issued, every early stage company ran around to get outside valuations in order to protect themselves.  C’mon, who would want a nasty 20% tax penalty.  As a rule of thumb, almost all companies are going through an outside appraisal for stock option pricing 12-18 months prior to an IPO (although, IPOs are harder to come by these days).  You are more than likely ok to do an internal valuation if there is not an exit or IPO in your future (future being the next 18 months).  Costs have come way down over the years and you can expect to pay between $5k-$15k.  You or your CFO should consult the appropriate consultants in this field.