In order to comply with 409A, a company may hire a third-party appraiser to perform a valuation. This valuation will ultimately be reviewed by several parties, which could include management, Internal Revenue Service, the company’s auditors or even the SEC. The following represents a non-exhaustive checklist of items that you, as a reviewer of the appraisal, may want to consider.
•Is the appraiser qualified? ◦Does the appraiser have previous experience performing 409A valuations? If not, does the appraiser have significant valuation experience that would suggest his/her competency? Has the appraiser’s work been successfully reviewed by auditors?
•Is the valuation date recent to the grant date? ◦Is the valuation date no more than 12 months prior to the grant date for the options? ◦Have any significant events occurred between the valuation date and the grant date that might affect value?
•Is the appraiser employing appropriate methodologies to value the common stock? There are generally two steps involved with this type of analysis. ◦The first step involves determining the overall company value. ◦The second step involves allocating the total company value among the various capital owners (e.g., preferred and common shareholders). As outlined in the American Institute of Certified Public Accountants (AICPA) guidelines, the three most commonly used valuation methodologies for the second step are the option-pricing model, probability weighted expected return model and the current value method. Note, the current value method is only appropriate in limited circumstances.
•Does the appraiser support his/her concluded marketability discount using evidence other than quantitative methods? ◦Many appraisers rely solely on quantitative methods such as put option models to quantify the marketability discount in a 409A analysis; however, IRS will look for evidence beyond quantitative models (e.g., an analysis of restricted stock studies) to support the concluded discount.
•Did the appraiser consider any recent rounds of financing or recent transactions of the company’s common stock? ◦Has the company had a recent round of financing that it views as arms-length and indicative of fair market value? If so, the appraiser will need to consider the round of financing in the valuation, and may need to rely on the pricing of the round to deduce the common stock value. ◦The secondary transaction market has grown considerably over the last few years, and private company common stock is increasingly being traded over secondary exchanges or otherwise sold to private buyers. The appraiser will need to consider whether this transaction is a relevant indication of value, which can be driven by factors such as the motivations of the buyer and seller, the block size, the level of due diligence performed and other factors.
•Can the valuation be used for both tax reporting and financial reporting purposes? ◦If you intend to use the appraisal to support your Accounting Standards Codification Topic 718 stock compensation expense (formerly known as SFAS 123R), the appraisal needs to state that it is valid for both tax and financial reporting purposes.