Andy_Smith129x173-1Finally! You are in due diligence.

You weren’t 100% sure if you could find a buyer, much less a sales price that would meet your and your investors’ expectations. But, the Letter of Intent is signed and you hope to be 60 days from closing – the team is already discussing the closing dinner plans. All you have to do is get the transaction “papered” and complete “confirmatory” due diligence.

Bankers and sell-side representatives love calling it “confirmatory” due diligence. “You have all the information that you needed to make an offer, and everything in the Information Memorandum is correct, so just confirm it and we are done!” If it were only so easy.

The due diligence lists are long, the data room is getting populated and the initial meetings are positive. Everyone is feeling good, as it always starts off on a positive note.

Typically, a young associate who is working through a standard due diligence asks the question:

“In reviewing your compliance with Section 409A, do you have a business valuation to support the fair market value of the strike price of the stock options?”

The general counsel likely has no idea so he pushes the question down the hall for the CFO to answer.

Section 409A is part of the American Jobs Creation Act of 2004. The piece of legislation covers a broad definition of deferred compensation, and stock options are a principal type of deferred compensation. Section 409A was enacted in part due to the abuses at Enron and MCI/WorldCom. It was originally announced in October 2004, effective January 2005, but was postponed, eventually not being fully effective until 2009.

In many ways, it was really a good housekeeping measure. The IRS did not want companies fabricating low values for its stock option grants and wanted something to support the valuations (the IRS knew it needed to catch up to the SEC which was strengthening its focus on valuation issues for financial reporting). Ironically, the higher strike prices for the stock options probably results in lower tax revenue since the ultimate capital gain is lower.

Issues like this provide buyers leverage during due diligence and help swing the pendulum their way as they finalize terms, and even consider re-trading the value. And, that simple band-aid solution, where the CFO makes a quick excel spreadsheet, hopefully it works, but per the IRS:

The valuation of stock based upon a reasonable application of a reasonable valuation method is treated as reflecting the fair market value of the stock.

Further, the CFO and business owner should be comfortable answering and supporting the following questions:

– Has the company estimated the Fair Market Value of the company’s stock in accordance with IRS definitions?
– Has the company selected a reasonable valuation method?
– Has the company reasonably applied the methodology?
– Has the valuation been performed by a qualified appraiser?
– What will the buyer think? What will the buyer’s due diligence team think?

Many private companies do not believe they need annual valuations. “We are too small, we are never going public, there is just a handful of us, it is too expensive.” Yes, you may never have plans to go public, but if you think you may ever be sold – you definitely need annual valuations.

The IRS exam risk may feel low (even though the IRS has trained hundreds of staff to identify valuation issues), but it is low hanging fruit for an M&A due diligence team to dive into. The severity of non-compliance penalties is one more deterrent to closing a deal. All amounts deferred can become immediately taxable, plus a 20% penalty tax.

If a business is granting stock options, it is mature enough to realize the fiduciary and compliance issues it faces. Our smartest clients embrace the annual valuation process, they make it part of their strategic planning process and they do not view it as part of the annual audit process or a compliance nuisance. They want another perspective on their value, they want to learn about the market. A 409A valuation is not just a good housekeeping practice; an annual valuation can provide much more to a business—It can be a strategic planning tool, and it is required by law.

The following post was authored by Andy Smith, CPA/ABV, ASA, CVA, Principal and Senior Managing Director, Valuation Services with The McLean Group.  Mr. Smith leads The McLean Group’s business valuation practice.  The McLean Group is a middle market investment bank which,  in addition to mergers and acquisitions, performs business valuations for public and private companies for transaction, financial reporting, stock option plan, and tax purposes.  For further information see