Current Practice Issues Pertaining to Sec. 409A

Since issuance of the AICPA Practice Aid, “Valuation of Privately-Held Company Equity Securities Issued as Compensation,” commonly referred to as the “Practice Aid,” several issues have arisen when determining the fair market value of common stock for Section 409A purposes. This same valuation often satisfies the financial reporting requirements outlined in ASC 718. We believe that a number of these practice issues will be addressed by the task force that is working on a new Practice Aid. These include the following:

  1. Recognition of the “back-solve” approach of applying the Option Pricing Method (OPM) as an acceptable valuation technique
  2. Whether it is preferable to run the OPM on an enterprise basis or an equity basis
  3. Whether it is appropriate to apply a discount for lack of marketability (DLOM) when deriving common stock value based on the back-solve method
  4. Best practices for establishing the volatility input when using a put model to quantify the DLOM

Recognition of the “Back-Solve” Approach

In the original Practice Aid, there was no mention of the back-solve approach. Since then the technique has come into widespread use.

The technique can be used in the context of an OPM when the company has completed a recent preferred stock financing round where a new outside investor has participated in the round. For example, if a company recently completed a Series C round of financing with a new outside investor participating at $2.00 per share, then most would agree that the transaction provides good valuation evidence that the value of the Series C is $2.00.

When there is a recent financing round that can be relied on to establish the value of a preferred security in the capital structure, the OPM can be used to imply (or back-solve) a value for the total equity of the company as well as the other securities in the capital structure. This technique is performed by solving for the total equity value input that yields a preferred C value of $2.00 in the OPM, given all of the other constraints and inputs in the model. A back-solve calculation obviates the need to establish the total equity value of the company based on fundamentals analysis, which can be a subjective exercise for early-stage companies. Or, it can provide an indication of the total equity value of the company that can be used to triangulate value based on a fundamentals analysis. We expect that the back-solve method will be formally recognized as a generally accepted valuation technique in the revised AICPA Practice Aid.

Whether to Run the OPM on Enterprise or Equity Basis

There has been some debate in the valuation community as to whether it is preferable to run the OPM on an enterprise basis or an equity basis. In most cases, this issue will not arise because most VC-backed companies are entirely financed with equity. However, this issue does arise when valuing the stock of PE portfolio companies, which may have incurred substantial amounts of leverage as a result of the buyout.

In our view, it is generally preferable to run the OPM on an equity basis. We do not believe that an option pricing model is the best method to value cash pay interest-bearing debt. There are other models, like an income approach, that are better for valuing debt. Also, in many instances, the fair value of debt can be established with reference to a transaction and there is no need to establish value based on a valuation model. Of course, care should be taken when running the OPM on an equity basis to make sure that the volatility input properly reflects the degree of leverage in the capital structure of the company versus the public comparable companies. All other things being equal, higher leverage usually results in a higher volatility input.

Is DLOM Appropriate When Deriving Common Stock Value Based on the Back-Solve Method?

There are those in the valuation community who assert it is inappropriate to apply a DLOM when the value of common stock is derived using the back-solve technique. This is because the preferred stock value which the back-solve is based on already reflects the value of an illiquid security.

While we understand this argument and recognize that there is not an active market for preferred securities in a development stage company, we believe that these securities have a much greater degree of liquidity than minority common shares because of all the control rights that preferred shares generally possess. It is our view, therefore, that application of a DLOM may still be appropriate even when deriving the value of common stock based on the back-solve technique.

Best Practices for Establishing the Volatility Input When Using A Put Model to Quantify DLOM

Use of a put model to quantify the magnitude of the DLOM has become an accepted valuation practice in recent years. One of the key assumptions going into the put model is the volatility input. Since the underlying security for which lack of marketability is being determined is the common stock and since the common stock is generally junior in the capital structure to all other securities, care must be taken to adjust the volatility input so that it properly reflects the position of the common stock in the capital structure. We understand that this can lead to substantial discounts (e.g., > 50%). Conceptually this may be appropriate given the risk associated with being junior to the preferred in liquidation. However, we have not established a position on this issue and await any guidance that may be presented in the pending AICPA Practice Aid.

For more information on valuations for Sec. 409A and ASC 718 purposes, contact your VRC representative.