Startup companies frequently have to confront this issue. After the founder stock issuances, the company will want to be able to grant stock options to new hires. Internal Revenue Code Section 409A requires that stock options be granted at fair market value (FMV) to avoid adverse tax consequences.
How to Determine Fair Market Value
The law does not require that companies hire an independent third party appraiser to value their stock, but it may be very helpful to you if you do. What the law does require is that the valuation be determined by the “reasonable application of a reasonable valuation method.” The regulations state:
Factors to be considered under a reasonable valuation method include, as applicable,
- the value of tangible and intangible assets of the corporation,
- the present value of anticipated future cash-flows of the corporation, (i.e. DCF method)
- the market value of stock or equity interests in similar corporations and other entities engaged in trades or businesses substantially similar to those engaged in by the corporation the stock of which is to be valued, (i.e. Comparable publicly traded companies method)
- the value of which can be readily determined through nondiscretionary, objective means (such as through trading prices on an established securities market or an amount paid in an arm’s length private transaction),
- recent arm’s length transactions involving the sale or transfer of such stock or equity interests, and
- other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders, or its creditors.
One should attempt use all of the above recommendations before making final conclusion. One should also reconcile different indications of value. FMV of common stock does not equal value of preferred stock in the latest round of financing or post-money valuation from the latest round. In fact, FMV of the common stock will always be lower than preferred stock because of liquidation preference given to preferred.
AICPA Practice Aid
“Valuation of Privately-Held Company Equity Securities Issued as Compensation – Accounting and Valuation Guide” commonly referred to as the “Practice Aid,” provides guidance on determining the fair market value of common stock for financial reporting requirements outlined in ASC 718 (old SFAS 123R). The same valuation satisfies the IRC 409a requirement. The Practice Aid is used by all qualified valuation professionals (hint: ask potential service provider if they follow the AICPA Practice Aid to avoid problems down the road when IRS or the auditor reviews the valuation).
In order to come up with fair market value of common equity to establish option strike price the valuation expert has to follow a two-step process:
- Determine Business Enterprise Value (BEV) – this is done by using discounted cash flow methodology and/or comparable transaction and/or comparable publicly traded companies approaches. Most of us are somewhat familiar with these approaches as they are the same used for any other business valuation.
- Allocate BEV to all of its invested capital: debt, preferred and common equity. This has to be done very carefully, as it needs to reflect all of the preference and priorities given to various classes of preferred stock. This part could be highly technical as, the leading value allocation method between preferred and common is the Option Pricing Method and involves series of option valuations.
One of the new techniques introduced in the revised 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. See this post for more info on using the “back-solve” approach.
Marek Omilian, CFA, Managing Director, Value Prism Consulting – Marek manages the delivery of valuation and decision support analysis. He has 20+ 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. Office: 206.262.5695 or cell: 404.307.8194. firstname.lastname@example.org, www.valueprism.com