Previously, only private companies that were serious IPO candidates worried
about valuing their common stock. These companies obtained a valuation to avoid
a "cheap stock" issue with the SEC when filing an S-1. As a result of Section
409A, which took effect in 2005, private companies at all stages of development
are now obtaining independent valuations to support option grants for tax
purposes, not just IPO candidates. Even companies that are at a very early stage
of development are seeking independent valuations in setting the strike price of
employee stock options.
Auditors are cognizant of this development and since the granting of stock
options is also a financial reporting issue, they will want to know how the
company established the strike price of its options. If the company relied on an
independent valuation, its auditors will want to see the valuation report. Our
valuations frequently end up in the hands of a company's auditors even if the
valuation was originally obtained for tax purposes.
Dual Purpose Valuation
A valuation report that provides the fair market value of the common stock
to satisfy Section 409A can also provide the fair value of the common stock to
satisfy financial reporting requirements. This "dual purpose" valuation will
provide consistency between book and tax accounting treatment, and will ensure
that the company does not have to obtain a second valuation to satisfy its
auditors. We recommend using the same valuation and allocation methods for both
purposes. We adhere to the allocation methods proscribed in the AICPA Practice
Aid, Valuation of Privately-Held-Company Equity Securities Issued as
Compensation (the "Practice Aid").
The valuation will generally not be accepted for financial reporting purposes if
it does not comply with the new methodologies outlined in the Practice Aid. The
tax guidance is less specific. To our knowledge there is no proscribed valuation
methodology or guidance comparable to that contained in the Practice Aid.
Section 409A, however, mandates that the valuation be done using reasonable
valuation methods and that the valuation professional has the proper experience
and training.
We have found that the allocation methods recommended in the Practice Aid tend
to produce a higher common stock valuation than other methods which may be
acceptable for tax purposes. Consequently, we have been asked by potential
clients to employ the methods that will produce the lowest common stock
valuation since the valuation will be used for tax purposes only. We contend
that the valuation of a development-stage company's common stock is best
estimated using the methods in the Practice Aid, regardless of the purpose of
the valuation, and therefore, that it is inappropriate to apply different
methods for book and tax.
Valuation Process
Valuation of development-stage companies is one of the most challenging
assignments due to the wide range of potential valuation outcomes. Moreover, the
industries these companies compete in, such as the technology, life sciences and
other high growth industries, are specialized and complex.
Despite the complexities, the valuation process can generally be broken down
into two basic steps. The first step is to establish the total equity value of
the company. The second step is an allocation of the total equity value to the
various equity securities that comprise the company's capital structure.
The Practice Aid provides little guidance concerning the first step, other than
which methods to apply at what stages of development, and that the valuation is
best obtained contemporaneously as opposed to retrospectively. In establishing
the total equity value of an enterprise, the analyst will typically use as many
of the generally accepted valuation methods and techniques as possible. We use
the following methods to establish the equity value of the company: (i)
comparable public company analysis, (ii) comparable acquisitions analysis, (iii)
comparable private company financings analysis, and (iv) discounted cash flow
analysis. For very early-stage companies, we often consider a cost or
asset-based valuation approach.
Allocation Methods
Undoubtedly the greatest contribution of the Practice Aid concerns
allocation methods and not valuation methods. An allocation of the total equity
value to the various securities that comprise the company's capital structure is
typically completed using one of three generally accepted methods: (i) the
current value method, (ii) the option-pricing method or (iii) the
probability-weighted return method.
Use of the current value method is only accepted when liquidity is imminent
or when the company is at a very early stage of development. If liquidity is not
imminent, either the option-pricing method or the probability-weighted return
method is recommended. There is no requirement that both methods be used. The
option-pricing method may be more suitable for earlier-stage companies when the
timing and valuation surrounding a future liquidity event is less defined. Both
the option-pricing method and the probability-weighted return method tend to
produce higher common stock valuations than the current value method.
Valuations for Section 409A are complex. We recommend hiring a valuation
firm familiar with the methodologies described in the Practice Aid. If the firm
is unfamiliar with the Practice Aid, it is unlikely that the valuation will
satisfy a company's auditors. For more information, contact your Valuation
Research representative or Justin Johnson at (415) 277-1803. VR
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