BPM
Search

Finding the Balance of Value in 409A Business Valuations

Why Paying Less Is Not Always Better for Your Business 09.02.20

Corporate business leaders and finance executives understand valuations are a critical component of stock option issuance for both tax and financial reporting purposes. Independent valuations are required to accurately reflect the fair market value and fair value of the Subject Company and there can be ramifications for poorly done analyses. Acquiring an accurate, supportable business valuation is essential for stock compensation, avoiding potential tax penalties, streamlining the audit review process and minimizing hurdles in exit scenarios.

It is not uncommon for early-stage entities to prioritize low fees in selecting service providers for certain compliance-based valuations, particularly valuations for Internal Revenue Code (“IRC”) Section 409A support. The least expensive sticker price may on the surface appear desirable. However, we encourage companies to be cognizant of some of the shortfalls of lower-end service providers. Certain providers offer valuation services as an add-on service and may primarily offer software solutions for cap table management, with the 409A analysis being a hook. Often these providers market their services to potential clients touting low fees but what we often observe is that these analyses lack the requisite level of thoughtful, rigorous financial analysis, which often leads to challenges, risks and back-end costs, especially for companies no longer in the “startup” stage. For example, when it comes to the annual audit, a low-end valuation is more likely to lead to additional challenges, time and, ultimately, cost. Additionally, a poorly-done analysis may also have implications for the company and their employees if it is later determined the value estimate from these firms is determined to be below fair market value.

Low-Cost Business Valuations: A False Economy

Unfortunately, those who are pulled in by the misleading claims of low-cost providers learn quickly that all valuations providers are far from the same when it comes to quality.

Thankfully, there are a few signs you can look out for when evaluating your valuation service provider in order to avoid these potential issues.

  • Potential Issue: The provider exhibits a reputation for bias towards below-market-value valuations, particularly 409A valuations. Some providers have made a name for themselves for the tendency to deliver valuations for the lowest possible fee. In fact, this feature is what draws many unsuspecting businesses to these providers in the first place. However, we would suggest that while companies may meet their objective of paying the least amount of fees on the front end, the valuations from many of these low-cost providers will not stand up to audit firm scrutiny due to the poor quality of work being performed. In short, we have found the quality of work and apparent effort put into these analyses often matches the level of fees. For example, we recently reviewed an analysis performed on behalf of one of our firm’s audit clients. This company had not completed a new equity financing for over 15 months. The low-cost provider elected to use this dated transaction as a basis for the updated IRC section 409A valuation analysis and not perform any other fundamental valuation approaches. This approach would not stand up to scrutiny and is just one example of unsupportable corner cutting we are seeing with alarming frequency. While certain providers seem to have been using these questionable practices for a while, it is more likely that a consistent pattern of low valuations will, sooner or later, attract the regulators’ attention — a move that may ultimately draw scrutiny towards the companies that procured these services. Needless to say, and unfortunately for our client, BPM ultimately recommended the client have a more rigorous analysis performed as their stock compensation expense was not adequately supported by the analysis and the firm hired to perform a supportable independent valuation on their behalf.
  • Potential Issue: Valuation staff is mainly junior-level and inexperienced. Valuation is a complex and often very subtle subject matter, and each valuation requires significant judgment — judgment that calls for a level of expertise, which can only result from many years of direct experience and training. The low cost provider’s business model calls for significant volume with respect to the number of valuations they can perform and experienced touched may be significantly lacking.
  • Potential Issue: The team spends as little time on each valuation as possible. Low-end valuation providers are focused on volume and selling other services, not on valuation quality. This results in a tendency to rush out work. The fact is, quality valuations take time. We have found that many of the analyses are performed by junior personnel, who often follow a “playbook” where the objective is to perform the least amount of thoughtful, rigorous analysis possible, to match the fee they are charging the client. If your valuation provider gets decisions in a suspiciously short amount of time or without asking for much input from you, then you are probably not receiving an accurate valuation of your business’s fair market value.

Individually or together, these qualities of a valuation services provider can add up to legitimate risk for the companies who use these services. As noted previously, a determination of a company’s fair market value is required under IRC Section 409A. A 409A valuation determined by the IRS to be miscalculated results in steep penalties for the recipients of stock-based compensation by imposing a 20% excise tax when certain design or operational rules contained in the section are violated. This is just one of the many risks associated with obtaining your company’s valuations from a low-end provider.

The key takeaway is that hiring low-cost providers comes with a certain level of risk. The risk is borne by both the Company and their employees. While the cash outlay initially may be lower, there can be significant costs incurred on the back-end related to re-doing the valuation, additional fees incurred as part of the audit firms review process, delay in issuance of financial statements and the potential of tax penalties, to name a few. We encourage our audit clients to use reputable firms that have a track record of providing supportable, rigorous analyses that will stand up to potential scrutiny. The additional upfront fees can help avoid additional significant issues on the back-end.

For Rigorous, Objective Valuation Services, Trust BPM.

BPM’s Valuation and Appraisals practice stands out as a fully-certified, established provider with a long history of in-depth work that helps clients achieve their goals.

One of the country’s largest West Coast-based accounting and advisory firms, BPM has been providing valuation services to companies of all sizes for decades. Our practice leaders bring their many years of experience and multiple professional certifications directly to bear, with high touch on each valuation project. Our client-focused values and system ensure you will never have any problems getting through directly to our practice leaders.

Our team possesses a deep knowledge of IRS and AICPA guidelines to ensure your valuation meets current standards, and we are fully versed in the complex capital structures and allocation methodologies required to produce accurate, defensible valuations.

To learn more about how BPM can fulfill your company’s valuations needs, contact BPM Director Kemp Moyer or Director Mike Ruane.