As we approach year end, we at Thorpe Capital Group are getting many more calls for 409a and 123R valuation work so I thought this would be a good time to post about what we are seeing as best practice in this area today.
Stepping back just a moment, "409a" refers to Internal Revenue Code section 409a and "123R" refers to Financial Accounting Standard 123R, both dealing with equity compensation issues, including stock options.
Our clients have been asking us this year to value their common stock as required by 409 and they've been using the common stock valuation to allow them to calculate equity compensation expense using Black-Scholes for 123 purposes.
Valuing common stock in a venture backed business is challenging. Typically, preferred shareholders have liquidation preferences and other rights that make their shares substantially more valuable than the common shares.
Imagine a scenario that is frankly not that uncommon: the current enterprise value of the business is equal to or less than the aggregate liquidation preference of the preferred shareholders. In this case, the common shares would appear to be worthless. In liquidation, the common shareholders would get nothing. But considering that the business is not about to be liquidated, the common shares have value--much like out-of-the-money stock options.
It is exactly this sort of complexity that is effectively requiring that venture-backed businesses obtain independent, third party valuations of their common stock.
Section 409 requires an annual analysis to satisfy the IRS. That, howver, may not satisfy your auditors with respect to the requirements of 123, which requires an essentially contemporaneous valuation of the equity compensation when it is granted.
For this reason, most of our clients are setting up programs of having their common stock valued more than once each year and up to four times--once each quarter.
While I hope this is helpful, this subject is complex. You should seek advice from both your legal counsel and your tax and audit advisors. If you have questions, I'm happy to field them by e-mail.
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