There are a few ways to go about determining the fair market value of the shares in your 83b election. If your company is early days, i.e. pre-revenue, pre-investment (arm’s length or otherwise), pre-IP, and has minimal assets on the books, then you might be able to use the par value of the shares for the fair market value (verify this with your lawyer/accountant). However, if your company does not fit these criteria then you will need to calculate the fair market value using the accepted AICPA guidelines.

The three accepted approaches for determining the fair market value of your company are the Asset Approach, the Income Approach, and the Market Approach. After using the appropriate approach to determine the fair market value of your company you will then need to determine the value of your relevant share class. If your company only has one share class of shares then you can divide the enterprise value by the number of common shares and apply any relevant discounts (a discount for lack of marketability for example) to determine the value of your individual shares. If your company has more than one share class then you may need to leverage the option pricing model or an alternative method to determine the value of your individual shares.

Do you need a professional determination of your company’s fair market value? If so please contact us for a free consultation.

There are no mandatory certifications to perform a 409A valuation, but the IRS does require that an appraiser have significant knowledge, experience, education and training. When choosing a 409A provider there are a couple of things you should consider: the first is whether the individual meets the IRS standard, the second is does the individual have the experience and reputation that ensures you will receive a quality report.

On the first point, the IRS standard does not specify any certifications or specific qualifications to perform a 409A valuation. The IRS standard for “significant experience” from the 409A final regulations is as follows:

“Generally, a person will be qualified to perform such a valuation if a reasonable individual, upon being apprised of such knowledge, experience, education, and training, would reasonably rely on the advice of such person with respect to valuation in deciding whether to accept an offer to purchase or sell the stock being valued. For this purpose, significant experience generally means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the service recipient operates.”

In general this could mean an MBA and/or CPA, someone with at least 5 years relevant experience, and specific training in 409A valuations.

The second thing to consider is does this person/firm have a reputation for producing a quality report?

As a firm we have seen valuations performed by individuals who may have met the IRS standard, but the reports they produced did not pass due diligence or audit standards. These sub-par reports are generally thin, we have seen them as short as 3 pages, with brief, unsubstantiated conclusions. These unsupported valuations can lead to serious implications for employees in two ways: if the stock was undervalued there are tax liabilities, or if the stock is overvalued then employees can be left with options that are under water.

When choosing a provider you should be sure that the appraisers have the knowledge, experience, and education required, that they have worked with external auditors (the Big 4 accounting firms often require more supporting information and detail than the IRS for 409A valuations), and that the report they produce will provide the necessary background and support for the valuation

If you are looking for a qualified, experienced, and cost effective 409A valuation provider, you have come to the right place.
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Steps in employing the asset approach are:

1)     Start with the balance sheet – ideally this will be “as of” the same date as the valuation date
2)     Restate assets and liabilities to fair market value where necessary – this can be the most judgmental step in the asset approach
3)     Identify unrecorded assets and liabilities and what their impact will be on the valuation – these may be off-balance sheet commitments or assets that are not on the balance sheet

Most of the items on the balance sheet are valued in a very straightforward nature.  Cash is cash.  Marketable securities can also be as easy as cash to value due to a stated market value.  Accounts Receivables and Prepaid Expenses typically have a fairly easy valuation.  Property, Plant & Equipment (“PPE”) and Inventory of a company can be more difficult to value.  These categories of assets should be considered carefully and valued appropriately.

There are times when a third party may be used to value certain elements of the balance sheet.  PPE is a good example of this.  For example, most valuation specialists are not specialists at valuing land and many companies may own land.  The same can be true for a machine used in production.  A company may have purchased the machine for one price and depreciated it to another.  However, the value of the machine may different from either of these values based on what it could be sold for on the open market.

Liabilities can also provide similar judgmental decisions for a valuation specialist.  While accounts payable and many accrued expenses are straightforward in their value due to a specific amount stated on an invoice, a liability such as a warranty accrual or a litigation accrual can be far less clear in its fair value and what it should be carried at during a valuation.  Significant consideration should be given to these more opaque items on the balance sheet when performing the valuation.

A last item where judgment may come in to play is with intangible assets, such as trademarks.  Self-created intangibles are not put on the balance sheet of a company and therefore do not automatically require valuing and adding to the balance sheet.  However, intangibles added through acquisition or purchase may exist and the skills of the valuation specialist need to be considered in whether or not to utilize a third party to value the intangibles.

The simplest way of thinking about the asset approach is:

Assets – Liabilities = Asset Approach Value

This also equals “Equity” on the balance sheet.  This is a very rough view but still a way in which someone could begin to gauge the value of a company through the asset approach before beginning a deeper look into each of the line items of the balance sheet.
Considerations that need to be made when using the asset approach are:

-        Premise of Value
-        Control
-        Marketability
-        Asset or Income based business
-        Going concern

The asset approach, whether ultimately relied upon or not, is important for a valuation specialist to consider in a 409A valuation.  Although used less often for operating companies which derive value from their income statement, an experienced valuation professional will still consider the impact a company’s assets will have on the value of that company, whether for 409A valuation purposes or otherwise.

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Step 1 – Determine the needs of the company

Before starting a valuation, we establish whether a 409A valuation is right for the company in question. We also need to determine the most appropriate valuation date. In some cases, we will recommend a company wait several months before getting their 409A valuation so they get better value for their money (a 409A valuation has an expiration date).

If the company knows they need a 409A valuation and we can quickly determine the valuation date they need for their report, this first step may only take a few minutes on the phone. In other cases, this step involves engaging several people at the company including the board, investors, management, legal counsel and others. In that case it may take weeks to determine whether moving ahead with an appraisal and choosing a valuation date is appropriate.

Step 2 – Sign the engagement letter and collect payment

We use a digital signing system that makes signing the engagement letter fast and easy. We accept instant payment via wire and PayPal. We find it usually takes between a day and a week for us to receive these from the client.

Step 3 – Upload company documents

Using our secure web form, clients can quickly and easily fill in information about their companies and upload the necessary documents. However, in some cases this may take some time. A company might have to draft its 5 year financial projections. Also, in cases where the valuation date recently passed, companies will take some time to produce year to date financial statements. We have had clients complete this step within an hour and others have taken several weeks.

Step 4 – Complete draft 409A valuation report

We commit to complete the draft valuation report within three weeks. There are times when we may have to ask for additional information or documents. Provided those requests are responded to quickly, we usually complete the draft report within two weeks.
In cases where the company requires a faster turnaround, we do our best to satisfy those requests and have turned around valuations in as short as 3 business days. While this is not the norm, it is possible.

Step 5 – Draft review

Before receiving the final certified valuation report, we provide our clients with the opportunity to review the draft report. Next, we meet to discuss the assumptions and inputs to the valuation to ensure we have described the company accurately. If revision is required, it may add a few days to the total engagement time although most of our clients have been satisfied with their valuation the first time around.

Step 6 – Final certified 409a valuation report

Once the draft valuation is agreed to with management, we request a representation letter from the company which we provide. After this letter is signed and received, we deliver the final valuation report through a secure download link.

How much time is required for a 409A valuation?

In summary, the time required for a 409A depends on the unique situation of the company being valued. We have had valuations that only took 5 business days from the time the client first contacted us until when the final certified report was delivered. On the other end of the spectrum, the process has taken several months for other clients.
For planning purposes, we suggest companies start the process one to two months before they need the valuation to allow themselves adequate time to prepare the documents and properly review the draft report. However, if you need your 409A valuation in a hurry, contact us and we will do everything we can to provide it to you quickly.

Are you ready to start your valuation now?
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Industry Analysis

There are several sources to leverage when researching the industry for a company. The first step is to identify and define the correct industry. For US based companies the two most accepted industry classifications are the Standard Industry Classification (SIC) and the Global Industry Classification Standard (GICS).

Once the industry has been identified the analysis of the operating environment focuses on factors that impact the specific industry. Some of the factors impacting the industry, beyond those covered in the economic environment section of the report, include customers, suppliers, substitution products/services, access to capital, and government. Frameworks can be leveraged for an organized approach to this analysis. One commonly recognized framework is Michael Porter’s 5 forces, which focuses on the factors driving rivalry within an industry. Sources to leverage for the industry analysis include current news articles, studies, and published reports. It is important to ensure that the publication date is in line with the valuation date and that the sources being used are reputable.

Competitor Analysis

Identifying and understanding a company’s competitors is important when valuing a company for several reasons. Successful competitors can threaten a company’s access to customers and impact the long-term growth of a company, nascent companies or technologies can make current products and services obsolete, and competitor companies can be used as Guideline companies when utilizing the market approach for determining the fair market value of a company.

The problem with solely relying on a company’s own assessment of its competitors is that, surprisingly, many companies have not done a full competitive analysis of their own market. Or if they have, they have only focused on direct and established competitors. Direct competitors are usually easy to identify, they are the companies offering the same product or service as those produced by the company. To understand a company’s position in the market however, a broader scope beyond direct competitors needs to be considered. Are there indirect competitors out there who produce a product/service that meets the same customer needs as those that company meets, but through a different product/service? Are there indirect competitors out there who are working on producing a product/service that could render the company’s offering obsolete? These are all factors to consider when analyzing the competitive environment for the company.

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For the purposes of this discussion, the focus will be on the discounted cash flow method and how it can be applied.

The first step in the valuation process, performed internally or externally, is to determine the future cash flows or “projections”. This will be the responsibility of the company’s management if using an external valuation specialist. The specialist should review the projections for reasonableness. The projections are typically performed for the upcoming five years. Although this is not a hard and fast rule, it is a rule of thumb that is commonly applied. Revenues and expenses should be projected forward from current results. The resulting amount should be appropriately tax affected to determine what the free cash flows of the entity will be. Other adjustments that should be considered are cash related items such as CAPEX, depreciation and amortization, to name a few.

After the free cash flows are determined, the entity’s numerator of the calculation is largely in place. Next, the denominator is the focus. The rate of return, or discount rate, for more developed companies is often determined through the Build-Up Method. CAPM is used in some circumstances, but the inherent difficulty in identifying a “beta” for the CAPM calculation causes many valuation specialists to use the Build-up Method. While this type of approach works for a company with more history, a new company or one just beginning to generate income and free cash flows poses a different challenge.

Investors seeking to assess a younger company may choose not to apply the income approach as it may not be applicable due to a lack of results on which to base projections. However, if there is a basis to work from, using the Build-up Method may not be appropriate. The rate of return for companies that are younger can vary quite a bit. Amounts from 20%-80% are often used for companies that are early-stage. The less risky and more reliable the projections, the closer the rate of return is likely to be nearer to the 20% end of this spectrum. Riskier, younger ventures with less proven results upon which to base the projections may use a discount rate closer to the 80% end of this range.

Taking the free cash flows discussed as the numerator and applying a rate of return, or discount rate, will result in the present value of future cash flows. The sum of these for the five years, based on the reasonable adjusted projections, provides one half of the value to be calculated.

Not many companies will simply end at five years. The valuation needs to also take into account the additional years of cash flows to be obtained. These cash flows can often be even more significant than the five years already detailed out. The terminal value, as this next amount is known, is generated by applying a long-term growth rate to the company’s free cash flows and discounting this total back to a present value as was done with the first five years’ projections.

When calculating the terminal value, the growth rate should consider the stage of the company and how it is likely to grow in the future. Many times, the United States GDP can be used as an estimate for this future growth. For well developed companies, exceeding this is unlikely. For earlier-stage companies, exceeding this is not uncommon.

The sum of the present values of the five year projected free cash flows and the terminal value provides the total enterprise value from the Income Approach.

• Advantages
• Widely recognized
• Flexible in addressing companies of many different stages and natures
• Simulates a market price even if there is no active market
• Disadvantages
• Relies on hypothetical projections
• Utilizes a discount rate with many variables in determining the appropriate figure

The Income Approach, whether ultimately relied upon or not, is important for a valuation specialist to consider in a 409A valuation. Working with a company to determine future free cash flows can be valuable in learning more about the company.

Are you ready to start your 409A valuation? Contact us, and one of our appraisers will be in touch and we can get your valuation started.

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An Example of IRC 409A Penalties

An executive in California received 50,000 stock options valued by the company’s board. The company had a recent round of funding in which the preference shares were valued at $20/share. The board decided that a fair price for the stock options would be $2 – 10% of the value of the preferred shares.

The actual ‘fair value’ of the shares, when properly valued, was $5/share. Therefore, the options the executive received were undervalued by $3/share, which results in her receiving a $150,000 benefit on paper.

The executive would then be assessed for

• 35% tax on the $150,000 ($52,500) plus a
• 20% federal penalty ($30,000), and a further
• 20% California state penalty ($30,000)

meaning she would have to pay out $112,500 of the theoretical $150,000 benefit in taxes and 409A penalties. She may even be required to pay the tax and penalties before she cashes out her options.

To make matters worse, if the value the common stock is less than $2/share when the company goes public or gets acquired, then the executive may have had to pay out $112,500 and won’t receive a penny from the ‘benefit’ that was assessed.

But Wait, That’s Not Fair!

I hear you, but we don’t make the rules. We do, however, help companies all over the USA avoid getting into issues with IRC 409A, and help their employees avoid 409A penalties, by providing a fast, easy, and affordable 409A valuation service. Had the company hired Simple409A, they would have only had to pay $2498 for a qualified, independent valuation. That would have saved the executive $110,000!

The standards of quality and content for a 409A report are largely being driven by the Big 4 accounting firms from an auditing perspective. The AICPA Practice Aid has become the handbook for firms performing 409A valuations and contains guidelines in acceptable valuation and allocation methodologies. A 409A valuation is not just crunching the numbers for a company, it is taking into consideration the bigger picture of the environment and the economy in which the company is operating to help build an accurate picture of how much the company should currently be valued.

Based on our experience at Simple409A, the following is a good 409A valuation report template, or at least a 409A report example. A 409A Report should be 30+ pages and generally follow detailed analysis using this format:

Engagement overview

Part of Section 409A details the safe harbor protection that comes with having an independent, qualified party perform the 409A valuation. The engagement overview defines the relationship between the 3rd party and the company.

Overview of the company being valued

This section describes the company, its current product offerings, market share, and future growth outlook. It also details the company’s financial history, equity structure, management structure, and key employees. The company overview should include a look at leverage points or capacity constraints within the company.

Overview of the economic environment

It is important to consider the economic environments in which the company is operating. Monetary policy, foreign policy, and economic stability are all factors that will effect the company’s valuation.

Industry and competitor analysis

The industry overview typically contains not only an analysis of the current industry the company is operating in, but also performs a SWOT analysis of where the company currently sits in its industry. The competitor analysis reviews the direct and indirect competitors of the company in order to provide context for the company’s relative position in the industry.

Valuation theory overview

This section gives an overview of the generally accepted methodologies used in the valuation including the Asset, Income, and Market Approaches and the equity allocation techniques including the Black-Scholes model.

Enterprise valuation

This is the section that details the fair market value calculation for the company as a whole.

Allocation of equity

Once the fair market value has been calculated the value must then be allocated to the various share classes. Then a single share can also be discounted for lack of marketability or lack of control.

Summary and Results

This section discusses the findings and presents the value for 1 share of common stock. Usually this is all management cares about, however the previous sections are critical in making the IRC 409A valuation defensible when it is audited.

Certification

After concluding the objective analysis of the company, the report authors certify the valuation report with their credentials. A certified 409A valuation report assures management, auditors, and the IRS that it meets safe harbor requirements.

It is recommended that companies use a qualified, independent valuation firm to perform their 409A Valuation. We would of course be happy to help you with that.

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• Articles of Incorporation
• Company Bylaws

If you have made any changes to your articles of incorporation, such as adding classes of shares, then you will have to provide:

• Amended and Restated Articles of Incorporation

Company Information:

• Management Biographies (can be a link to the relevant page of your company website)

If you have had a code 409A valuation performed before, then:

• All Previous IRC Section 409A Valuations

For all companies, even if you incorporated last week:

• Year to date Income Statement for the period ending on the valuation date
• Balance Sheet as of the valuation date
• Trial balance

If your company has been around for more than a year:

• 5 years of Income Statements (or since incorporation)
• 5 years of Balance Sheets (or since incorporation)
• 5 years of Statements of Cash Flows (or since incorporation)

Companies with meaningful revenues have to provide:

• 5 years of revenue, expense and tax rate projections

What do I mean by meaningful revenue? Think about it this way: is it possible to imagine using your revenue to value your company? If yes, then get your 5 year projections ready and submit them along with your other documents. If you submit your projections and your private company appraiser doesn’t do a discounted cash flow calculation, then you are no worse off. If you don’t and they want to run the calculation, then it could delay your valuation.

Companies that have subsidiaries which have their own separate accounts:

• All the above financial information for any subsidiaries

If your company has issued stock options or warrants:

• A schedule of options and/or warrants
  

If your company has any outstanding debt (including convertible debt):

• Debt agreements

Other than the above documents, you will also be asked to provide some information about your company. But it is your company so it is likely have no preparation will be required to answer those questions.

Are you ready to start your 409A valuation? Contact us, and one of our appraisers will be in touch and we can get your valuation started.

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Guideline Public Company Method

The Guideline Public Company Method is founded on the concept that companies within similar industries or similar positions within their industries will have similar valuations or characteristics upon which a valuation can be based – whether that company is public or private. It is vital to understand the subject company’s market, product lines, plans, growth in order to identify comparable public companies. One difficulty in creating a set of guideline public companies is that larger companies often have multiple lines of business. When trying to value a smaller business, it may only compete against one of these lines and be difficult to compare metrics due to this.

Guideline Transactions Method

The Guideline Transactions Method is founded on the concept that detailed private company financial data is unlikely to be available but transaction value does become available, and, on such occasion, that valuation can be used as a tool to provide a valuation for other similar companies. Using this method can be useful where a sale or purchase is being considered or is under consideration as an exit strategy for company management. Additionally, if ownership interests of the company under review compare favorably to companies that have been involved in transactions it may be a benefit when trying to value the company. Typically, this is a controlling and marketable interest, but it could be the opposite being value as well – non-controlling and non-marketable. A main challenge in determining whether a transaction can be considered within a data set of comparables is the lack of information often present in research database or in the public spectrum.

For both of the above methods, ensuring the companies used for comparative purposes, both from a standalone value and transaction value, are similar to the company being valued, or that discounts and premiums are applied for dissimilar characteristics, is critical to the success of the market approach. The sales transactions are typically for a controlling interest, so the valuation specialist will need to discount if the company under review is not in a controlling position. The same consideration for a discount exists when looking at a guideline public company which is typically a very marketable and liquid asset compared to private company stock.

Backsolve Method

A valuation specialist also may use the backsolve method to solve for the implied equity value that is consistent with a recent transaction in the company’s own securities. The basis for application of this method is transactions in equity securities of the enterprise with unrelated investors or among unrelated investors themselves. In using this method, the valuation specialist should disclose in the valuation report the rationale for selecting the transactions deemed relevant (and for excluding other transactions, if any) and what adjustments were used in estimating fair value. In selecting the relevant transactions, the valuation specialist should consider whether those transactions involve any stated or unstated rights or privileges, any effects of which would ordinarily be factored out of any fair value estimate.

Each of the methods within the Market Approach has advantages and disadvantages. The Market Approach, taken as a whole, has the following advantages and disadvantages:

Advantages

• Straightforward, simple calculations
• Uses real, public data
• Does not rely on subjective forecasts

Disadvantages

• Difficulty in identifying comparable companies or transactions
• Lack of sufficient number of comparable companies or transactions
• Not flexible
• Raises the questions – How much data is there? How good is the data?

The Market Approach, whether ultimately relied upon or not, is important for a valuation specialist to consider in a 409A valuation. Gathering data about comparable companies and transactions will teach the valuation specialist a lot about the company under review and the competitors it faces.

Are you ready to start your 409A valuation? Contact us, and one of our appraisers will be in touch and we can get your valuation started.

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