How Important is a 409A Business Valuation? | A Cautionary Tale
There is plenty of literature out there on why companies need to keep up with financial reporting and tax obligations, but I want to share a story that illustrates the consequences and risks of not hiring a competent valuation advisor to do your 409A valuation. I could speak until I’m blue about the importance of valuation as it relates to financial and tax reporting, but I really think this story does a better job of driving the point home.
For discretionary purposes, I will call the company in this example, “DOOMED LLC”. DOOMED was semi-young software as a service (SaaS) company founded by millennial entrepreneurs. The company was gearing up for its initial public offering (IPO) and, up until this point, had been doing its own internal valuations.
The term “409A”is often used loosely. 409A refers to IRC 409A, which deals with deferred compensation in the eyes of the IRS—meaning it is related to taxes. Many professional advisors, CFOs and entrepreneurs refer to 409A when addressing matters that actually concern ASC 718 (financial reporting). This is an important distinction that we’ll cover another day.
What If You Don’t Update 409A Valuations? (Psst… you’ll regret it)
DOOMED didn’t have its financial reporting ducks in a row, to say the least. Because management had been doing valuations internally, they lacked proper documentation to support the stock option prices from the past two years. Like many companies, DOOMED didn’t realize just how complex business valuations actually were and, therefore, thought doing it themselves would be “good enough”. They also failed to understand the importance of timely, accurate valuations and the consequences of failing to have the valuations on hand. After receiving the initial SEC comments, DOOMED’s outside counsel contacted me to clean up the mess.
DOOMED’s attorney: “The SEC is all over us about our option valuations. Can you help? We need quarterly valuations for the last two years, and we need them quick!”
Yours truly: “No problem.”
We went to work. With a deep employee/advisor bench and vast experience in dealing with 409A, ASC 718, financial reporting and tax compliance—not to mention our experience in dealing with the SEC—we completed the eight valuations in about three weeks. The final work product passed SEC scrutiny with flying colors and minimal feedback. But the findings were clear. For years, DOOMED had been issuing options with strike prices that were well below Fair Value and Fair Market Value.
The Risks of Nonexistent or Bad 409A Valuations
You see, by trying to pinch pennies on initial, timely valuations, DOOMED ended up in a much worse position. Between the three weeks it took for us to complete the reports and the SEC review time, DOOMED lost its IPO window. In this short period of time, market volatility increased and the deal was dead in the water.
You might be saying to yourself, “So? That doesn’t seem so bad.” But that was just the beginning. The snowball effect that came next would jeopardize the entire company and stakeholders alike. After missing the IPO window, DOOMED had to pursue less favorable options, which severely diluted their current shareholders and forever damaged the company’s reputation. Not only that, but the employees and directors were now facing huge potential tax complications and penalties.
409A Tax Implications: A Little Advice from a Big Business Valuation Expert
I’ve seen many CFOs, controllers, and accountants fixate on the consequences of financial reporting errors, but they often overlook the tax complications that arise from issuing cheap stock options. If the strike prices aren’t set properly, the shareholders face the potential of paying taxes on phantom income as well as harsh tax penalties—even after the options may have expired or become worthless. This is just one real-world example of value destruction due to misunderstanding and not complying with tax reporting procedures and ASC 718 stock compensation expense guidelines. But there are plenty more cases like this out there.
Even though we were able to complete the valuations in a short amount of time, DOOMED’s lack of preparation cost them dearly. My hope is that this case study resonates with you, so your company doesn’t end up in a similar position. If DOOMED had performed its 409A valuations at the proper times, as outlined in Mark Sadauski’s article, “When Do You Need a 409A Valuation Update”, it would’ve hit its IPO window and had a much favorable outcome without tax complications. Please don’t make the same mistakes. Your company’s success may just depend on it.
If you’re looking for more information on business valuations or just need some advice, contact us today.
How much does a 409A Business Valuation cost? Find out in this article.
Rich Barth is Managing Director at Vantage Point Advisors, Inc. He has compiled nearly 20 years of international investment banking and valuation experience at firms including Goldman Sachs, HSBC Securities and Houlihan Lokey.