Offering employees a share in the company as compensation has long been a standard recruitment practice at venture-backed companies. However, the regulatory and enforcement environment in the last eight years has made this process more complicated than it used to be.
It all started in 2004, with the publication of the American Institute of CPAs (AICPA) Practice Guide on the valuation of equity of privately held companies. This was followed in 2006 first by the IRS requirement that companies implement Section 409a. Then we saw the collision of these new IRS standards with the Financial Accounting Standards Board (FASB) standards for the SFAS 123R, which have been more clearly codified under Statement 157.
Essentially, the FASB standards (which are considered the generally accepted accounting principles or GAAP) and the IRS standards each require companies to value these employee stock options differently. Although IRC 409A and SFAS 123R both apply to the calculation of the underlying value of stock topics, the 409A uses “fair market value” while the SFAS 123R is a GAAP standard and uses “Fair Value.”
Why Use a Dual-Purpose 409A Valuation
The use of a dual-purpose 409A valuation is to eliminate the overlap herein, in a way that is compliant with both IRS and GAAP standards. This “dual purpose” valuation helps create consistency between book and tax accounting treatments and helps a company avoid having to obtain a second valuation to satisfy its auditors. Many companies are now opting for dual-purpose 409A valuations for these reasons.
However, creating these documents in house often leads to either real or perceived conflict of interest. Rather than assuming the risk therein, many entrepreneurs and Chief Financial Officers are instead offloading 409A-related risk by hiring independent valuation consultants. This may mean allowing an outside party access to sensitive financial documents, but for companies who utilize safe sharing practices, the risk in sharing that information is minimal in comparison.