At KN+S we get asked at least once a week by a start-up CEO whether they need a formal valuation or not when they are issuing stock or options. Many angel investors, V.C.s and Boards often suggest to young CEO's not to waste the money and that the risk of any exposure is low. While this maybe true, companies need to understand that potential exposure down the road and the additional work it may cause. The answer to this question is that it will generally depend on many factors and the risk tolerance the Board and Management team have. But the rules are clear: it is up to the company and its Board to establish a credible fair market value for its stock.
Audit Risk
One thing companies don't want down the road in a due diligence situation, is to have the acquirer come back and tell them they see some areas that are of risk and that the company needs to issue a guarantee or representation so that they are not exposed. Or an audit two years out when the audit firm may not be able to issue the audit due to having no formal documentation on the valuation calculation.
Section 409A
About 10 years ago, the IRS adopted a code section 409A that addresses how a company should establish a fair market value when they issue stock or grants compensation or options below fair market value. There are steep penalties (possibly as high as 85% to the employee) should a company engage in issuing "below market compensation" that can affect both the employee and the company. The IRS Standards under 409A do state that if you are a very early company, as long you have someone with some financial acumen (i.e. significant knowledge and experience) that understand the standard valuation methodologies that a professional would address, you can undertake to do the work yourselves and document your findings on what the value of the grant is and you will be in compliance. We find these people are seldom available within the Company. Valuation methodologies that are acceptable are the discounted cash flows, comparison to comparables approach and market approaches just to name a few.
Cost and Timing
A typical valuation report by a professional audit firm usually costs between $6,000 and $10,000, although there are specialty vendors who may be able to offer a lower price for a narrow 409A valuation, though quality may be sacrificed, so caveat emptor. We advise that a company can use a 409A calculated figure for up to 12 months unless there are events within the company that would cause the valuation to change. While this can be a lot of money for a young company, we tend to advise clients to see it as an insurance policy. So as an investor, a mentor, an advisor or Board Director, make sure the companies you work with are aware of the risks that surround valuations and be sure they are not taking a penny-wise, pound-foolish approach.
About the Author
Jeffrey D. Solomon is the Managing Partner of Katz, Nannis + Solomon, PC. The firm is now ranked one of the Top 25 CPA firms in Massachusetts and its emerging business group has grown to be a true leader in Massachusetts. Jeff can be reached at jsolomon@knscpa.com.
