From 409A to audits, independent valuations are a popular topic of discussion these days…and for good reason. They can make all the difference in defending your position – and that of portfolio companies – with the IRS and financial statement auditors.

Q. Why do I need an independent valuation for stock options, as opposed to a valuation performed internally?

A. A decade ago we may have said, “You don’t.” But these days, the big picture tells us that you should only use an internal valuation if your in-house capabilities have the right expertise. Valuations come into play on too many levels to take a chance, especially when dealing with 409A (taxation of deferred compensation), GAAP and audit concerns.

Just as important, an internal appraiser needs to understand how the valuation will be defended if regulators take a closer look and require you to “show your work.” Also, your auditors will be assessing the valuation as part of their audit of compensation.

Q. You mentioned 409A in relation to granting stock options as compensation, which is common practice for us. What will an independent valuation accomplish?

A. On the tax side, under 409A, regulators may at some point be checking into whether the stock option was granted at Fair Value. An independent valuator gives you a safe harbor for these stock options when the IRS comes calling.

There are certain safe harbor provisions for internally prepared valuations, as well. However, your in-house appraiser needs to have qualifications similar to an external valuation expert in order to meet the standards.

If you don’t meet safe harbor and are deemed to have granted stock options at less than Fair Value, you’re looking at significant penalties: the recipient of the options will be hit with a 20 percent penalty on top of regular taxes and interest.

Q. Is 409A the main driver for independent valuations, then?

A. It’s certainly a big one, as is supporting your financial statement audit. Because the penalty is so significant, most companies are getting this done.

And from a VC perspective, there’s no doubt that portfolio companies should be appropriately armed. If they’re subject to an IRS challenge, suddenly the spotlight is on a whole pool of employees who have compensation as a result of stock options. If it’s determined that they were granted below Fair Value, you’re looking not only at penalties across the board but also a rash of questions from employees around the compensation strategy.

Q. Can I use the same valuation for financial statement audit support?

A. Generally, yes – and this is where GAAP expertise comes into the picture as well. Back in 2006 we were given the mandate to expense stock options, and they have to be properly valued. If auditors find that compensation expense is material to a financial statement, which many times it is, then the value of the company’s common stock is the major component in the calculation of that compensation expense. The worth of the underlying stock is crucial there, and auditors will be looking to see where you came up with the value and that the proper methodologies were used.

An internal analysis may get the job done depending on how material the stock options are to the financial statements, but being able to point to an external valuation report lends more credibility. And internal valuations may lend themselves to additional back and forth with auditors, which translates into more audit fees to get through the process. Look for a valuation expert that also understands GAAP and you’ll have a leg up.

Q. How often does a valuation need to be performed?

A. For tax purposes, a valuation is generally valid for one year as long as no significant events occur. For GAAP, there’s no one-year rule but rather an “as needed” approach as stock options are granted periodically. Each grant has to take into account the value of the company on the day the options are issued. So the timing of valuations depends on the significance of change in value and of the volume of grant activities.

Q. Are there other reasons for having an independent valuation?

A. From a business perspective, a valuation provides stakeholders with a sound understanding of the intended dilution resulting from Stock Options. Further, having an external valuation avoids potential conflicts with insiders.

This entry was posted on Monday, June 30th, 2008 at 8:00 am and is filed under Accounting, Audit, Fair Value, Q&A. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.