FAKE NEWS ALERT - 409A Valuations are Educated Guesses!

409A values, which started out as a way for the IRS to make sense of pre-IPO equity values, have become something more like bigfoot and all-you-can-eat restaurants. A joke just a decade ago, these values are now used by companies and the media as if they are truly representative of what the market thinks a company is worth. It’s time to set the record straight.

The Background

The Internal Revenue Code (IRC), including IRC 409A, was issued by Congress, interpreted by the US Department of Treasury via Treasury Regulations, and implemented by the IRS. The Financial Accounting Standards Board (FASB) determined that IRC 409A could be used as a company’s value for accounting purposes.

In October 2021, FASB issued ASU 2021-07, which states that private companies “may use a value determined by the reasonable application of a reasonable valuation method.” The date on which the valuation’s reasonableness is evaluated is the measurement date.

1. The following factors should be considered in a reasonable valuation:

a. The value of the tangible and intangible assets of the entity.

b. The present value of the anticipated future cash flows of the entity.

c. The market value of stock or equity interests in similar entities engaged in trades or businesses substantially similar to those engaged in by the entity for which stock is to be valued.

d. Recent arm’s-length transactions involving the sale or transfer of the stock or equity interests of the entity.

e. Other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation is used for other purposes that have a material economic effect on the entity, its stockholders, or its creditors.

f. The entity’s consistent use of a valuation method to determine the value of its stock or assets for other purposes.

2.    The scope of information to be considered in a reasonable valuation is all information material to the value of the entity.

3.    The following criteria must be met for the use of a previously calculated value to be considered reasonable:

a.    The value is updated for any information available after the date of calculation that may materially affect the value of the entity.

b.    The value is calculated no more than 12 months earlier than the date for which the value is being used.  

So, while FASB did provide some direction, at the end of the day, the number that one valuation firm may say is a reasonable valuation isn’t necessarily the same number another valuation firm arrives at.

For example, say a private company, Your Company, hires a valuation firm to come in, look at the books, apply the reasonableness rule and give our sample company a 409A valuation of $6.00 a share. YourCo then grants options to employees with a grant price of $6.00 per share. YourCo employees take the valuation as fact and believe their stock has a $6.00 value and begin looking forward to the next valuation coming in higher than $6.00.

The Truth

This all seems straightforward, so why the Fake News alarm? Well, remember, the valuation firm did their due diligence and came up with a reasonable number for accounting purposes only. Now let’s look at investors. They don’t care about the current 409A valuation. They are purchasing preferred stock and offer a price they can recover if the liquidity event is not successful but can be converted to common stock should the liquidity event be very successful. In this hypothetical, the investor offers $15.00 a share for 5% of fully diluted shares outstanding. Is YourCo now automatically updated to a new $15.00 409A valuation? Do you bring the valuation firm back to re-value the company, is the true value now somewhere between $6.00 and $15.00, or is it some other number completely?

YourCo may decide the new 409A valuation is now $15.00, but in a similar scenario, AnotherCo may find that keeping the existing 409A valuation is correct. If the decisions of each company meet the reasonableness test, there is no right or wrong.

The Challenge

By now, you are wondering what’s the point of this article. Over the past four or five years, companies have increasingly used the difference between their 409a Value (a fake guesstimate) and their most recent investor funding round (a value that is based on the expectation of a 2-10X value increase) to communicate employee equity value.

It is imperative that companies use the correct explanations and terminology when educating their employees. Employees need to understand that the company needs to do 409A valuations to use for tax and accounting purposes as well as setting grant prices. But employees should not rely on the 409A valuation as the actual value of their options or RSUs. Just like publicly stock prices, 409As can fluctuate up and down. And, 409A values are not founded on informed market transactions. The real value of employee options is not known until the shares are exercised and a liquidity event has occurred.

Conclusion

A 409A valuation is an important part of this process, but it should not be the only factor considered when determining the net worth of their grants. Our team at FutureSense is dedicated to helping you provide employees with the information they need to make informed decisions about their equity and become more responsible with the expansion of your personnel, to find out more about reputable consulting firms, contact us today, and let's get started!

About FutureSense 

FutureSense is a management consulting firm that provides integrated solutions to build and sustain human capital capacity. The firm can work with you by offering support and guidance to manage your workforce. To learn more about FutureSense, please visit FutureSense.com.