For privately held companies (particularly those sponsored by private equity and venture capital funds), getting the valuation process right the first time for equity compensation grant compliance is always the least expensive route in terms of both direct and indirect cost.

  • Review by Auditors. The potential for surprises in the audit review process related to equity compensation is most significant with new auditors and for new equity compensation plans. It is not necessarily safe to assume that valuation procedures used in the past will be sufficient to pass the audit review process. Communication with auditors on the front end in this situation is paramount to make sure that valuation procedures (or the independent valuation provider) will be satisfactory. Valuation analysis is always more expensive when it has to be done twice.
  • SEC Scrutiny. Preparing for an IPO is probably the worst time for a company to deal with fallout related to insufficient valuation procedures related to equity compensation. This situation quickly becomes very expensive. And the direct financial cost of compliance in this situation is often less burdensome than the distraction created at a time so close to the finish line when management most needs to be focused on execution of strategic objectives. For companies with even a distant prospect of IPO, robust valuation procedures for equity compensation compliance are necessary on the front-end.
  • IRS Review. Even for companies not contemplating a potential IPO, the possible tax penalties from IRC 409A make defensible valuation analysis a priority. Given the short life of IRC 409A as of this drafting, there is limited case history to develop clear expectations of IRS scrutiny related to 409A compliance. We do know that IRS audits related to 409A have begun picking up, and it’s likely that valuation reviews will follow suit. Drawing on our experience in other tax-related valuation matters, we know that thorough documentation and sound economic reasoning ultimately win the day. Given this uncertainty and magnitude of the consequences of 409A, it’s best to play it safe.

In general, it is safe to expect the level of scrutiny over equity compensation-related valuation to increase with the size of the equity compensation grant – both the absolute magnitude (in terms of dollars) and relative magnitude (as a percentage of total revenue or enterprise value). While complexity of the equity compensation grant or capital structure does not inherently increase scrutiny, it does make it more challenging to demonstrate clear compliance with tax and financial reporting regulations. With appropriate awareness, management can minimize total compliance cost by selecting valuation procedures appropriate to the situation and getting it right the first time.

Reprinted from Mercer Capital’s Financial Reporting Valuation Flash, April 2010.

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