409A vs. FAS 123R: A Tale of Conflicting Valuation Methodologies

New guidelines impacting common stock valuations may result in identical classes of stock being assigned widely varying values. The different methodologies acceptable under the criteria established for IRC Section 409A could create conflicting valuations, which would create varying results for FAS 123R purposes. Private equity firms may be particularly vulnerable to resulting inconsistencies because of the potentially dramatic changes in the equity values of their portfolio companies due to operational improvements and/or top-line growth. Clearly there needs to be a better understanding of the purpose and application of each methodology.

IRC Section 409A 

IRC Section 409A, enacted as part of the American Jobs Creation Act of 2004, imposes numerous requirements with respect to nonqualified deferred compensation arrangements. Stock options and stock appreciation rights must be granted with a strike price at least equal to fair market value of the underlying stock in order to avoid current taxation and potentially significant penalties to those receiving the options. For the purposes of determining fair market value, 409A requires that the valuation firm perform a “reasonable application of a reasonable valuation method.” Included in this “reasonable application” standard are the following considerations: (1) the value of tangible and intangible assets of the corporation (an Asset-Based Approach to value); (2) the present value of future cash-flows of the corporation (an Income Approach to value); (3) the market value of stock or equity interests in similar corporations and other entities engaged in similar trades or businesses (a Market Approach to value); (4) control premiums or discounts for lack of marketability; and (5) additional uses of the valuation.

In addition, 409A permits the use of a number of methodologies to allocate the company’s total entity value. Among these methodologies is an analysis of liquidation rights or the application of an option pricing model (either a Black-Scholes type of analysis or a probability weighted analysis). Each of these methodologies could be appropriate under different circumstances, and could produce very different values of common equity. The common equity value is of great importance for the analysis required by FAS 123R.

FAS 123R

FAS 123R requires that all share-based payments to employees, including stock options, be recognized in financial statements based on their fair values. FAS 123R provides that “observable market prices of identical or similar equity or liability instruments in active markets are the best evidence of fair value and, if available, should be used as the basis for the measurement.” If such information is not available, FAS 123R provides that fair value be estimated based on established principles of financial economic theory and applied in a manner that reflects all substantive characteristics of the instrument.

The application of 123R requires the use of a company’s common share price (value) to calculate the value of options. If a company has recently completed an analysis for 409A, one might assume that the common share value determined in that process could simply be imported into the 123R analysis. Because the common share value could vary greatly depending on which methodology was applied to allocate value between share classes in the 409A analysis, the values of the options considered in the 123R analysis could be inappropriate. Guidance is provided by the AICPA in a publication entitled Valuation of Privately-Held-Company Equity Securities Issued as Compensation.

The Conclusion

Comparing these guidelines clearly demonstrates why it is important to know the value of your company’s equity and equity derivatives. It’s possible that valuation methods used for tax reporting purposes will not be acceptable for financial reporting purposes – and vice versa.

Different methodologies used to allocate value between different classes of stock can often lead to discrepancies in value when the resulting common share price is then an element in an analysis for a completely different purpose. Understanding the purpose of your valuation will help to save money, time and effort and reduce the likelihood of inconsistent valuations. If you have an issue regarding the valuation of your private company’s equity, derivatives or liabilities, consult a reputable valuation professional who can understand all of your valuation needs and apply methodologies that are suitable for them all.

If you have comments or questions about this article, or would like more information on this subject matter, please contact us.
Daniel Kvarnberg

Valuation
dkvarnberg@pcecompanies.com
Orlando Area Office

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