On March 8, 2017, the New York Times published a piece addressing practice of stock option valuations. This article, by William D. Cohan, trashes the law that requires stock option valuations and the people (like us) who perform the valuations. Even the Securities Exchange Commission gets sideswiped. Predictably, the business valuation community has reacted negatively. There’s no way around it – this article accuses the entire stock option valuation “system” of being a great, big, fat con. If you make a living off of performing these valuations, it is, frankly, a piercingly hurtful piece. If you want to view the outrage first-hand, do visit the Valuation LinkedIn Group. The article rings true to me because for years I have heard many of the same comments made directly to me by investors, founders, and board members. However, I don’t view this article as a sneak attack – but rather a call to action for our profession to be reminded of our responsibility to the public trust, and an opportunity to educate the market on the strategic intelligence value that credible appraisals offer.
For those of you who aren’t up to speed on what 409a is and why it exists, here is the elevator pitch. At the height of the the first dot-com bubble, thousands of people were making millions of dollars by foregoing salary and accepting stock options instead. Many companies achieved liquidity relatively quickly (and with seemingly low risk), and billions of dollars of income went under-taxed or not taxed at all.
Accordingly, the government introduced Section 409a of the Internal Revenue Code. What 409a says is this: if you issue stock options, they will be considered current compensation if they are in the money at the time of issue. In other words, if you issue options at a strike price of $12, and the value of the underlying stock is $14, the $2 in theoretical profit you’d make by exercising (called intrinsic value) is taxable as current income. Cash tax payable on a non-cash income item. Yeah – it’s as bad as it sounds. However, the tax is deferred if you make them incentive stock options, meaning that they are underwater at issue. If you issue those same options at a strike price of $12 and the value of the stock is $10, you only pay tax when you do ultimately exercise the options – typically when the company achieves liquidity and the employee option holders receive payouts.
The accounting world, concerned that the compensation expense for stock options was being under-reported on income statements, issued new rules in parallel – requiring that all options issued be recorded as an expense at their fair value as of their date of issue. Originally, this was called Section 123R (I never did figure out if there was just a “Section 123” at some point) and now is called Accounting Standards Codification Topic 718. Mercifully, you can generally use the same valuation to comply with IRC 409a as ASC 718.
Now, here’s the kicker. The valuation in practice adds virtually no real compliance value because enforcement is so rare. SEC/PCAOB (the folks that oversee accountants’ audit practices) actions on stock option values are quite rare. You are more likely to be mauled by an escaped gorilla from your local zoo than you are to face a 409a action by the IRS, especially if you haven’t gone public yet.
There are instances, however, in which a 409a valuation can be important. If you have a stickler financial statement auditor (not all are), the ASC 718 side of the compliance exercise will be more carefully scrutinized. Getting a bad valuation of any kind through a good audit is painful and expensive. You’d rather be Han Solo in the Force Awakens than go through that. Also, if you plan to raise money from professional sources, the 409a valuation is often an important (I think overblown) due diligence issue. I have seen instances in which a gong-show valuation has made raising money from venture capitalists harder.
These exceptions notwithstanding, Mr. Cohan’s frustration with the entire 409a enterprise is justified. True – we didn’t write the rules. We didn’t even lobby for them. We didn’t invent the game – we are just the players. BUT, where we, as practitioners, must accept some responsibility lies in the fact that increasingly, an increasing number of the 409a valuations being performed barely (or fail to) meet professional standards (such as the Uniform Standards of Professional Appraisal Practice), and that reflects badly on all of us in the profession. Mr. Cohan is right – many 409a valuations don’t match up well with how the market prices early stage investments, and much of this has to do with cutting corners to make money on lousy fees (and also that some practitioners aren’t as good at understanding real-world transactions as they ought to be.) I’ve heard colleagues blame the clients for refusing to pay the fees necessary for a “good” work product, but nobody is forcing us to take the engagements. When people who make investment decisions for a living routinely complain (or joke) about how our work products are off the mark, that is something to which we need to listen carefully – not just blow off as complaining from a fee-sensitive cheapskate client or venture capitalist.
Our profession has a responsibility to do better, because the 409a exercise is undermining our collective credibility. It is already sufficiently difficult to convince clients that we can provide an informed understanding of the value of any privately-held company, especially startups (Arpeggio’s stiffest competition is the notion that business appraisers don’t know what they are doing.) Giving in to provide stripped-down, check-the-box valuations for race-to-the-bottom fees simply reinforces the hack image our profession struggles to shed. If we want to be more than the parking meter enforcement agents of the accounting world, we must position the 409a as an opportunity to inform the client about important and hard-to-see strategic intelligence regarding their businesses.
In order to restore our credibility in the eyes of the venture community, we must do the following:
If we do as I suggest, some of us (Arpeggio included) will lose work. Not every client wants to be educated – or can afford to be. Not every 409a client will seek funding or has a stickler auditor (or any at all). Checking the box may serve that client just fine.
We will have to overcome doubt in the market that we really can deliver on making a 409a valuation a strategically relevant investment. Doing so will require time and grit. I think it’s worth the investment; our profession and our livelihoods will be better off if we decide we can live without McValuations in our services suite, and stick to producing appraisals.
Cohan’s article is a bit of a hatchet job, but it’s also a wake-up call. The 409a business has been damaging to the business appraisal profession because, over time, some of our peers have collectively cast all of us in the b.s. business. When market participants scoff at our work and call us walking Magic 8-balls, we shouldn’t be blaming them – we should be prompted to self-examination. Business appraisers should be respected for knowing as much as anyone about how assets are priced in illiquid markets. The fact the opposite seems to be true in a critical segment of the market ought to be cause for reflection, reform, and re-focus.