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Monday, December 14, 2015

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The Hidden Costs of Poor 409A Compliance


Part I – The $1 million IRC 409a Valuation?  You’re Fired: the Hidden Costs of Botched Compliance
When was the last time you bought a service you understood little about and, for lack of any other reason, selected the vendor based on price?  Happens all the time with electricians, lawyers, mortgage brokers, auto repair shops, tax preparers.  And the consequences can be immense as the incompetent prey on the ignorant, often delivering little if any value for their fees.

One such field that gets lots of play is the compliance valuation performed primarily for IRC 409a to justify private company stock option strike prices, and secondarily for ASC 718 to account for equity based compensation.  Introduced by their respective tax and accounting jurisdictional bodies almost 10 years ago, the initial fear generated in the community of private companies (and public as we are now learning) was immediate and without parallel – the golden goose (cheap options) was under attack and no expense was too great in light of the potential gains from low priced options. 

As time passed, silence from the IRS prevailed[1]; financial auditors in the aftermath of the Enron debacle filled the void, reaching an accommodation with valuation service providers after imposing their methodologies and biases; and the emphasis shifted from the premium placed on the “quality” of  compliance to the “cost” of compliance.  That shift in attitude was driven in part by investors who informed their portfolio companies following the 2008 financial crisis that cash burn was to be minimized, and worse yet, that additional financing was unlikely.  While budgets were whacked to a pulp, the original purpose of securing the valuation to obtain a defensible opinion that met management’s objectives became subservient to “check the box” compliance at the least cost.

Indeed, we frequently see early stage companies buying 409a valuation services without regard to the quality of the work, the outcome, or the potential risks that lie ahead – unfortunately, as others identified these concerns years ago, this is a pervasive threat to defensible compliance.  The reason is in part due to a superficial understanding of what constitutes a quality analysis and to ignorance of the real costs of non-compliance.  To understand the quality issues, one would need to be conversant in valuation theory and practice, which is beyond the limited scope of this article.  However, being sensitive to a few high level metrics may help the unwary in the search for a quality valuation firm:

  • Test the credentials of the firm and its professionals:
    • How long in business
    • Who are their clients, referral sources, partners
    • How many valuation opinions issued
    • How many of these opinions have been audited and successfully defended
    • What is the scope of valuation services offered (tax, financial reporting, litigation, transaction)
    • How knowledgeable about your industry, your business model, and your stage of development
    • How conversant with your capital structure
    • Where are its valuation professionals located
    • Are they available on short notice and are they responsive

Because most buyers are not capable of sorting through the qualitative considerations, they default to the amount of fees they will incur as the basis of their decision; in reality, some lower priced opinions are superior to more highly priced ones.  Nevertheless, it requires an understanding of more than the fees paid, rather a thorough analysis of the valuation to make a determination of its quality.

Perhaps a quantification of some of the expenses resulting from poor compliance will make a bigger impression than attempting to explain and quantify the many judgments that are required for a thorough and defensible valuation analysis.  In so doing, hopefully buyers and beneficiaries (employees, optionees, management, and directors) of such services will begin to prioritize what’s really at stake and focus on the competence of their valuation service provider to furnish a defensible argument to those who will challenge the opinion.

Valuation expenses can be categorized into buckets:

  1. Fee paid for the valuation opinion
  2. Fees paid to both the valuation firm and accounting firm to review the opinion
  3. Implied cost of senior management time (CEO/CFO) to referee the two

If the opinion is well prepared, documented, and defended, then the process should end after a reasonably cursory review by the accounting firm and, hopefully, nominal incremental fees. 

However, if the reviewing entity cannot achieve comfort in the analyses and responses of the valuation firm, it may be necessary to have a different valuation firm undertake a new opinion, requiring more fees and more review and more management time.  One can safely assume that the revised opinion’s outcome will be a higher strike price than that originally used for the option grants (it was probably a low value that triggered the auditor’s review in the first place); it will also cost significantly more than the original opinion.  The implications of resetting to a higher strike price on options that have already been granted are profound and will have devastating impacts on optionees, management, and the Board, calling into question the judgment of those responsible for managing the original valuation project.  For the unfortunate, jobs and careers may be on the line.

The discussion in Part II will quantify the magnitude of expected fees for defending a valuation of poor quality.  In Part III, the penalties imposed by the IRS and state (CA) will be examined.

Part II – The Magnitude of Expected Fees for Defending a Valuation of Poor Quality
Coming into focus now should be an understanding of how a poorly prepared valuation turns into a time and cost debacle as valuators battle and hourly billing charges escalate.  Let’s put some hard numbers on the assumptions.  For our analysis, we’ll assume an early stage high tech company that has not yet engaged financial auditors.  In our simplistic example, the buyer cannot distinguish quality and is left to rely on quoted fee as the basis for the engagement.  After bargaining with three or four valuation firms, the winning bid (perhaps a sole practitioner in between jobs) comes in at a fraction of the high bidder. 

Optimistically, the completed opinion is furnished within a month, option grants are made, and silence reigns.  All is forgotten until one of the following events occurs, probably years later (nearly 10 years for the IRS’ case against Sutardja), and management (which may be new since the original valuation) is left scrambling to find the opinion, and more problematic, find the valuator that can defend it:

  1. The company hires accountants for a financial audit (there may be subsequent SEC reviews)
  2. The company is being acquired
  3. The IRS audits a major optionee (likely to be a C suite executive)

In each of these cases, the valuation opinion will be reviewed – for financial reporting compliance in the case of 1 and 2 immediately above, and for tax compliance in the case of 2 and 3.  Our pending example will deal specifically with either 1 or 2, as the IRS has reviewed many tax valuations (for estate and gift purposes) but none of note for 409a compliance has been fully adjudicated.

If there are significant issues with the valuation analysis, the accounting firm’s valuation group may recommend to the client at the outset to seek a new opinion from a known valuation firm.  Companies will be tempted to resist that suggestion as it implies there may be a change in the concluded value and it comes with a price tag that may be $10,000 to $20,000, or more.  If the decision is to try to defend the existing opinion, the time racked up by the accounting firm and the valuation firm in responding to interrogatories and conference calls could easily approach $35,000.  If a successful defense is the result then it may well have cost the company more than $40,000 for that opinion.  However, if the challenge is sustained, then a new valuation will need to be performed.  Our bargain valuation will now have cost in excess of $50,000, probably three times or more the fee of the highest priced vendor on the initial bid.

Summarized in the following table are the incremental costs relative to an opinion which does not stand up to peer review and one that does:

Cost Element Non-Compliant Valuation Compliant Valuation
Valuation firm fee to defend opinion $10,000 $ *
Accounting firm fee to review opinion $25,000 $ *
Incremental management time $2,500 $ *
   Total costs before fees for new opinion $37,500 $ *
Base fee for new opinion $15,000 $ 0
Valuation firm fee to defend new opinion $ * $ 0
Accounting firm fee to review new opinion $ * $ 0
   Total costs after fees for new opinion $52,500 $ *

*Probably some review costs but nominal in amount

Before we leave the discussion of expenses related to the accounting review, the company may yet have to face additional challenges to its 409a valuation from an acquirer’s due diligence if it is sold or from the SEC if the company makes it to registration.  In these cases, delay stemming from poor compliance may impact critical time-sensitive negotiations, and resultant transaction values. 

Up to this point, we have only considered challenges mounted by accounting firms to test the company’s compliance with ASC 718, expensing of equity based compensation (soft expenses - and as you will soon see, the company has been fielding only soft balls to this point).  It’s time to deal with the big, hairy gorilla in the room – the IRS – to be discussed in Part III.

Part III - The Tax Penalties Imposed by the IRS and Franchise Tax Board
The real money on the table lays ahead and underlies the ultimate purpose for the 409a valuation report: tax compliance.  That is the province of the IRS…and, in the case of California, the Franchise Tax Board – neither warm to tax evaders, as governments are cash starved in a weak economy, and their penalties and interest prove it.  For the taxing entities, the penalty is 20% to the IRS on the taxable income and is triggered from vesting date, not exercise date, and 20% to the FTB, plus underpayment interest at a combined 6%. 

It seems reasonable that the trigger for a challenge to a 409a valuation will be the audit of a high income shareholder following a liquidity event for the company (who received large grants of stock options – see Sutardja for an example of one such optionee) – in other words, years after the original valuation and strike price were set.  This takes on significance because the clock on the underpayment interest starts at the time of vesting, so it is not improbable that there may be 5 to 10 years of accrued interest that will be due, in addition to penalties.  Furthermore, it may be difficult to find the valuator who initially performed the valuation, leaving the document to defend itself.  As you will see below, non-compliance cost our hypothetical taxpayer at least $1,000,000 or 40% of the proceeds - probably substantially more with the imputed interest on the underpayment as well as tax and legal fees. 

Let’s ok at the math:

Item Assumptions Notes:
(1) Strike price $5
(2) FMV at grant $7 As later determined by the IRS
(3) FMV at exercise (M&A event) $10
(4) Shares exercised $500,000
(5) Federal income tax rate 39.6% Assumes highest tax bracket in 2013
(6) CA State income tax rate 12.3% Assumes highest tax bracket in 2013
(7) Federal 409a penalty 20.0% On amounts includable in taxable income
(8) CA FTB 409a penalty 20.0% On amounts includable in taxable income
(9) Medicare 1.45%
(10) Taxable income $2,500,000 (3) minus (1) times (4)
Taxes and Penalties
(11) Federal income tax $990,000 (5) times (10)
(12) Federal 409a penalty $500,000 (7) times (10)
(13) CA income tax $307,500 (6) times (10)
(14) CA 409a penalty $500,000 (8) times (10)
(15) Medicare
Legal and tax adviser fees
$36,250
???
(9) times (10)
(16)    Total tax and penalties $2,333,750 Sum of (11) through (15)
Balance to grantee* $166,250 (10) minus (16)
Maximum implied return 6.7%

*Before underpayment interest due from vesting date (3% to each of the IRS and FTB, 6% combined)

It is rational to assume that the respective taxing authorities would not stop with this taxpayer if such bounty is available from other shareholders.  Likely targets include all senior level executives and employees who received sizable option grants – and therefore, have potentially large tax bills.  There may be additional charges to the company (and perhaps restatements) to the extent the taxing authorities determine that the shareholder is under withheld relative to the implied income from the mispriced options.

IRC409a is a mine field for those who play at its boundaries, potentially being left with an indefensible opinion gotten during their watch.  While serious financial costs for the employee/optionee accrue, the management, Board, and company are likely to suffer even more punitive consequences. 

Also on the table, but difficult to quantify, are the lost gains to the optionees resulting from strike prices that were set higher than necessary because of errors (including errors in judgment) in the valuation analysis.  The bottom line is that it’s not only important to get a competent, defensible opinion, but also one that optimizes the outcome for all constituent parties (including accountants and taxing authorities). 

Hopefully, you leave this discussion with a better understanding of how a poorly prepared valuation can destroy lots of bank accounts, not to mention lives and livelihoods.  Those who get the message will begin to probe and challenge the quality of the valuators and valuations being offered in their defense when the accountants and IRS call.

1This may be about to change as there is a case before the Federal Court of Claims (Sutardja v. United States) in which the IRS is asserting 409a penalties for underpriced options against the CEO of publicly traded Marvel (MRVL.).

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