Board pushing to not have a valuation done at a major milestone. Thoughts?

Ignoring the financing and continuing to issue stock options using the valuation report from eight months ago will take the company out of the safe harbor created by IRC 409A -- and put the employees who receive the options at risk for substantial penalty taxation (if they are in California, the combination of federal and state taxes, penalties, and interest is nearly 90% of the option gain).

The language of IRC 409A requires that a company which wants to issue stock options using the safe harbor (i.e. shifting to the IRS the burden of proof in a dispute) must determine the fair market value of its common stock by using a "reasonable valuation method" which is "reasonably applied." It goes on to say that a valuation method is not reasonable if either (a) it was calculated more than 12 months earlier or (b)it "fails to reflect information available after the date of the calculation that may materially affect the value of the corporation (for example, the resolution of material litigation or the issuance of a patent)."

Most valuation experts think that a new equity financing "materially affects the value." And so does the IRS (Revenue Ruling 59-60 lists factors to consider in valuation and one of them is sales of stock). So, a new valuation report is the safest course of action.

Obtaining a new valuation report is an expense. But, think of it like an insurance policy which protects against confiscatory penalty taxes for the employees who receive the stock options (and gives the company an edge in any subsequent interaction with the IRS).

Since your last 409A valuation was only 8 months ago, it might be more economical and still meet IRC409A requirements to work with the valuation firm to do an update of the original valuation instead of doing a whole new one. It is worth negotiating with your valuation firm, especially if your revenues have been flat.

I appreciate the comment about going back to the valuation firm which provided the valuation report eight months ago -- that is good advice. However, in the eyes of tax and GAAP accounting standard setters there is no such thing as an "update" to a valuation report. A completely new valuation report will be needed.

According to the Uniform Standards of Professional Appraisal Practice (USPAP) approved by the Appraisal Foundation (an organization created by Congress after the previous financial meltdown, the S&L crisis), in Business Valuation there are only two types of valuation reports: an Appraisal Report and a Restricted Use Appraisal Report.

The latter can be shorter than the former, but -- as the name implies -- its use is restricted, in this case "for client use only." That means every valuation report prepared for use by others (anyone outside the client such as the client's audit firm, the IRS, etc.) must be a full length Appraisal Report. And USPAP is very clear about what must be included in such a full length report -- everything.

If you go back to the valuation firm which provided the valuation report eight months ago, it may be able to reduce the fee for the new valuation report slightly to reflect the prior experience with and knowledge of your company. But, by the same token, the new class of securities will have to be worked into the Black-Scholes option allocation model and there will be other changes to the report as well, entailing new work. Basically, there aren't any shortcuts in the valuation world.

Thanks for that insight, Jim. My expertise is in equity compensation administration and corporate governance, not valuation, so this information is very useful and I will be sure to ask my clients for clarification the next time they tell me they've "updated" their 409A valuation.

I would suggest major events the REDUCE commercialization risks should trigger a new valuation for a early stage company.