IRC 409A: Update your common stock valuation

IRC 409A

Save time and money when raising a new preferred round.

Guest Post By Marek Omilian

Commonly referred to as the “Practice Aid,” the AICPA “Valuation of Privately-Held Company Equity Securities Issued as Compensation – Accounting and Valuation Guide,” provides guidance on determining the fair market value of common stock for Section 409A purposes. This same valuation often satisfies the financial reporting requirements outlined in ASC 718. Revised back in 2013, one of the new techniques introduced in the updated Practice Aid is the concept of using the latest round of funding to “back-solve” for values of the company and its preferred and common securities.

When applied in the context of an Option Pricing Method (OPM), the technique can be used to allocate value to various rounds of Preferred and Common Stock. To reflect all of the preferences in the OPM model, a valuation expert must possess a good understanding of the method and carefully review the operating agreement of the company.

The key input for the OPM is the value of the company, which is traditionally arrived at using discounted cash flow and/or comparable companies (Market Approach). This initial step of arriving at the company value can be skipped if the company has completed a recent preferred stock financing round where a new outside investor has participated in the round. For example, if a company recently completed a Series A round of financing with a new outside investor participating at $1.00 per share, then this transaction provides good valuation evidence that the value of the Series A is $1.00. We can then solve (“goal seek”) for the total equity value input that yields Series A value of $1.00 in the OPM, given all of the other constraints and inputs in the model. We can also arrive at fair value of common stock as it is part of the OPM model. This approach is more accurate, faster, less time consuming and less costly to all involved (see table below).

IRC 409AHowever, the “back-solve” can only be done (and should be done) when the round is recent. If the company passed any milestones (first customer, new version of product prototype, any new contracts with partners, patent approval, etc.) shortly after the financing round, the “back-solve” would not apply as, presumably, value of the company has changed.

In such cases, valuation expert should follow the “two-step” process:

  1. Determine value of the company using DCF and/or Market Approach.
  2. Allocation value to preferred and common using OPM or other allocation methods.

 

Marek Omilian, CFA, Managing Director, Value Prism Consulting – Marek manages the delivery of valuation and decision support analysis.  He has over twenty years of consulting and line management experience working with companies in such areas as:  valuations; business case and ROI analysis; decision support analysis; shareholder value enhancement analysis; mergers, acquisitions and divestitures; synergy identification; and capture in a post-merger business integration. 206.262.5695 or momilian@valueprism.com, www.valueprism.com