This Frequently Asked Question (FAQ) post addresses typical questions from companies regarding obtaining a valuation or appraisal.  This document is co-authored by Bruce Wynn of Morris, Manning & Martin, LLP and Dan Branch of Taylor Consulting Group, Inc. The following questions are commonly asked of technology and business services companies.  We hope this information is helpful to you.  Please note that there are additional questions that will be relevant in this area and you should consult your legal, tax and accounting advisor with any other questions.

1.  When do I need a valuation or appraisal?

Answer:  There are several situations where a valuation or appraisal may be appropriate.  A few of the common situations are listed below:

a. Determination of Stock Option Exercise Price – Stock options fall within the Financial Accounting Standards Board’s (FASB) definition of share-based payment arrangements, as described in FASB’s ASC 718 Compensation – Stock Compensation (formerly FAS 123(R)).  Within that accounting standard, “fair value” is established as the required measurement objective for such share-based payment arrangements (which includes stock option plans).  Entities are required to account for share-based payment transactions involving employees (the setting of a stock option exercise price is an example of such a transaction) using fair-value-based methodologies.  Accurately determining the “fair value” of a financial instrument typically requires complex financial analysis and in-depth knowledge of several accounting standards.  With increased scrutiny from auditors, the SEC, and other regulatory agencies, technology companies (even private ones if they are planning to go public within the next three to five years) should consider using an independent valuation expert to assist with such analyses.  Additionally, such analyses may also fulfill compliance issues surrounding Section 409A of the Internal Revenue Code (the “Code”).  There are exceptions to the ASC 718 requirements (e.g., an employee share ownership plan (ESOP) may be exempted); therefore, it is recommended that clients or interested parties discuss with their accountants or other advisors about how their technology company may be impacted by the ASC 718 requirements.   

b.  Merger & Acquisition Support – Performing detailed evaluations of your proposed transactions (as well as a complete comparison of each) before negotiations begin ensures accurate planning and execution once negotiations are over.  Valuation experts can assist in analyzing and evaluating your proposed transactions, without the full-blown financial commitment that an investment bank would require.  Valuation experts can assist in determining and articulating the value and risk drivers inherent in a proposed transaction to ensure that your growth strategy aligns with your business objectives – without an investment banker’s inherent incentive to “get the deal closed.” 

c. Tax Issues (for example, Gift or Estate Planning) – International, federal, state, and local regulatory authorities increasingly stress the need to support various financial and tax positions with thorough and independent valuations.  These valuations can strengthen your tax strategies and address the broad spectrum of regulatory requirements.  An independent valuation expert should apply thorough analysis, independent objectivity, and knowledge of case law to your tax-related valuation engagements.  Additionally, experienced valuation experts typically have performed hundreds of valuations of closely held entities (including C corporations, S corporations, limited liability companies, and partnerships); therefore, their experience can ensure your tax-related valuation meets all regulatory requirements.

2.  With regard to stock options, is there a legal requirement to have a valuation or appraisal every time that a company grants stock options?

Answer: There is no formal legal requirement for a valuation or appraisal every time a company grants stock options, but it is a best practice to obtain an independent valuation for common stock (or other securities) which may be purchased pursuant to options granted in the context of an option or incentive plan.  In some cases, companies will obtain an annual valuation and seek an update for any interim option grants to confirm the fair market value of the common stock and to set the exercise price at the time of an option grant.

3.   What is Section 409A of the Internal Revenue Code (“Code §409A”) and how does it relate to the requirement or need for obtaining a valuation or appraisal?  How is Code §409A relevant to stock option grants?

Answer:  Established by the American Jobs Creation Act of 2004, Code §409A provides new requirements applicable to “nonqualified deferred compensation plans,” which includes arrangements such as certain stock options, phantom stock, and certain stock appreciation rights.  Code §409A generally requires that stock options and stock appreciation rights have an exercise price equal to or greater than the fair market value of the underlying common stock as of the grant date to avoid harsh tax consequences.  If the stock option or stock appreciation right exercise price is less than the fair market value of the common stock, additional taxes and “penalties” may be assessed depending upon whether certain requirements are met.  For purposes of Code §409A, fair market value is to be determined by the “reasonable application of a reasonable valuation method.”  Regulations under Code §409A provide a “safe harbor” whereby a valuation resulting from an appraisal is presumed to be “reasonable” if the valuation is performed by an independent appraiser, and the date of the valuation used is within the last 12 months (provided that the valuation method used and the application of that method cannot be shown to be “grossly unreasonable”).  Accordingly, most private companies utilize an independent valuation expert to perform an appraisal to determine the fair market value to take advantage of this safe harbor.  It is helpful to know that appraisals that are performed to meet the requirements of ASC 718 (formerly FAS 123(R)) may potentially also be used to satisfy the requirements of Code §409A; this may enable the company to fulfill two regulatory requirements for the price of one analysis.  Because the two standards are different (e.g., ASC 718 requires fair value measurements whereas §409A requires fair market value measurements; ASC 718 takes a corporate perspective while §409A takes a personal perspective), concluded values could be different; your independent valuation expert will be able to help you make that determination.

4.  What is the accounting standard ASC 718 (formerly FAS 123(R)) and how does it relate to the grant of stock options and the need for a valuation or appraisal in connection with stock option grants?

Answer:  Any pre-IPO company will want to ensure it understands and correctly applies the accounting guidelines and standards that dictate the financial reporting of stock options.  Otherwise, incorrect accounting of compensation expense related to previous equity awards may force a company to restate many years worth of financial statements – a nightmare for a company in the run-up to IPO.  The GAAP accounting standard that codifies the requirements for the treatment of stock options is FASB’s ASC 718 Compensation – Stock Compensation (formerly FAS 123(R)).  As required under ASC 718, both public and private companies must record compensation expense for stock options, even if those options have no intrinsic value.  An important aspect of ASC 718 is that the “fair value” of the underlying common stock and the “fair value” of the stock option itself must be determined as of the grant date.  It is this key point (determining the fair values as of the grant date) that usually catch unknowing companies in the “cheap stock” trap.  (An example of the cheap stock trap: a company may spontaneously award a deserving employee with options that are fully vested and have a $0 strike price; because of the “cheap stock” deal, the company may not know it just burdened itself with substantial compensation expense as well as hit the employee with a personal income tax bill.)  Determining the fair values of the common stock and the stock option itself requires significant judgment and complex financial analytical tools.  Therefore, as an added level of comfort for directors and management, most private companies utilize an independent valuation expert to perform an appraisal to determine those fair values on the grant date.

5.  What documentation should be obtained by a company in connection with stock option grants to support the valuation or appraisal used to determine the exercise price for the stock options?

Answer:    Because ASC 718 requires reasonable and supportable estimates for each assumption used in the analysis, a company should (at the least) maintain the documentation that demonstrates the rationale and application of each assumption.  For instance, the expected term of the stock option should be based on the contractual term of the stock option as well as the employee’s expected exercise and post-vesting behavior; therefore, an auditor or SEC inspector will want to see the supporting materials and calculation used to develop the expected term.  When a company uses an independent valuation expert to perform such an analysis, the expert, knowing the documentation requirements and audit process, typically provides the necessary documentation that supports their conclusion of value as well as a written report describing the assumptions used and methodologies applied.  The level of documentation and inclusion of a written report varies depending on the agreed to scope of work and desired deliverables.

6.  Can a company conduct its own valuation and use that for purposes of complying with the above or is an independent valuation required?

Answer:  There are no prohibitions against a company conducting its own valuation.  However, because of the complex valuation methodologies utilized in stock option-related valuations, a company’s self-determined valuation would likely increase the level of scrutiny applied by the company’s auditors and regulatory agencies.  In such cases, if the IRS challenges the company’s valuation, it may have an advantage if the company is not fully versed in valuation principles and methodologies.  According to Code §409A, valuations must take into account standard valuation practices and must also take into account certain factors mentioned in regulations.  Additionally, the person or persons performing the valuation should have significant knowledge, experience, education, and training in performing valuations.  In relation to ASC 718 requirements, accurately determining the “fair value” of a financial instrument typically requires complex financial analysis and in-depth knowledge of several accounting standards.  With increased scrutiny from auditors, the SEC, and other regulatory agencies, technology companies (even private ones if they are planning to go public within the next three to five years) should consider using an independent valuation expert to assist with such analyses.

7. What are the general costs and timetable for obtaining a valuation or appraisal for stock option purposes?

Answer:  A rough estimate of costs is $5,000 to $12,000, though company-specific factors may warrant a cost outside of this range.  The cost will depend on several factors including:

a.  Complexity of the capital structure (a company with several preferred stock tranches will require more time to analyze than a company with only common stock);

b.  Complexity of the corporate organizational structure (a company with foreign-based subsidiaries of partial ownership will require more time to analyze than a company with only wholly-owned domestic subsidiaries);

c.  Size of the company and the complexity of the company’s operations (a company with multiple or multinational business units and multiple product lines will require more time to analyze than a company with only one business unit and few products lines); and

d.  Timetable for completion of analysis (an analysis done in a compressed timetable typically requires additional staffing and resource levels compared to an analysis done in a normal timetable).

A typical valuation for stock option purposes will take two to three weeks.  Factors that will positively impact the timetable include the valuation expert’s familiarity with the company, timely receipt and availability of the company’s data, good responsiveness by the company’s representatives assisting in the valuation process, and participation of company personnel who are knowledgeable of the pertinent facts and circumstances.

8.  In the area of mergers and acquisitions (M&A), when are valuations or appraisals required?

Answer: Though valuations can provide important information to assist key decision-makers in analyzing and evaluation proposed transactions, valuations are not required.  Typically, a company contemplating a transaction will perform a valuation to analyze the impact of the transaction.  The company may perform its valuations internally or enlist an independent valuation expert.  If performed internally, a company should ensure the personnel performing the analysis have the requisite knowledge and experience with valuation principles and methodologies.

9.  Are there legal requirements for a valuation or appraisal in an M&A transaction?

Answer:  There is not a formal legal requirement for a valuation or appraisal in an M&A transaction.  As mentioned previously, valuations can assist key decision-makers in analyzing and evaluating proposed transactions.  However, key decision-makers typically desire analyses that can ensure they fulfill their fiduciary duties.  Such analyses are typically called fairness opinions.  Fairness opinions can provide proof in litigation that the decision maker used reasonable business judgment in making a decision on behalf of others.

10.   What is a fairness opinion and why is it important?

Answer: A fairness opinion is a statement by a financial advisor that, from a financial point of view, the consideration or the financial terms in a merger, acquisition, divestiture, securities issuance, or other transaction between specific parties are fair to a specific party. Fairness opinions serve two purposes:

a.  To provide key decision-makers with relevant, independently produced information; and

b.  To act as factual proof in litigation that the decision maker used reasonable business judgment in making a decision on behalf of others. 

An opinion of fairness, from a financial point of view, is not an assurance that the highest possible price will be received in a proposed sale or that the lowest price will be paid in a proposed purchase.  It is the financial advisor’s conclusion that, based on financial factors, the exchange of the consideration given and received in the proposed transaction or the proposed transaction’s financial terms falls within a range which the parties to the transaction might reasonably agree.

Business decision-makers often need to understand whether a potential transaction is reasonable, from a financial point of view, to their businesses or to shareholders of their businesses.  Sometimes this need may be a result of their fiduciary obligations; other times it may be simply to augment their business judgment.  Acting with informed business judgment when considering a proposed transaction often can be the central issue in litigation against boards of directors or other decision makers exercising their fiduciary duty.  What is “fair” can be disputed, especially by contending parties in a lawsuit.  An opinion from a financial advisor can support the contention by a board of directors, special committee, general partner, or trustee that it acted with informed judgment in deciding on a proposed transaction.  For instance, boards of directors have a fiduciary duty to the shareholders; therefore, fairness opinions requested by boards of directors will demonstrate the fairness (or unfairness) of the transaction from the perspective of the shareholders.  If boards of directors are found to have been negligent in their fiduciary duty, even after the fact, the board members may be personally liable for such negligence.

Because there can be many “perspectives” present in a transaction, it is not uncommon in very large transactions to have multiple fairness opinions performed in relation to a single transaction (each performed by separate, independent financial advisors with a specific financial perspective, or point of view).

11. Is a fairness opinion required in connection with every M&A transaction?

Answer:  As previously mentioned, a fairness opinion, though not required for M&A transactions, can provide key decision-makers with relevant, independently produced information as well as act as factual proof in litigation that the decision maker used reasonable business judgment in making a decision on behalf of others.  Also, by utilizing an independent valuation expert, as opposed to obtaining a fairness opinion from a banker involved in the transaction, the independent valuation expert’s fairness opinion can provide an extra check on the terms of the transaction.  Because the size and components of each transaction are different (i.e., there are rarely “plain vanilla” transactions), the key decision-makers will need to determine if a fairness opinion is warranted on a transaction-by-transaction basis.

12. What are the general costs and timetable for fairness opinions?

Answer:  Costs vary considerably.  The cost for a fairness opinion will depend on several factors including:

a.  Complexity of the transaction;

b.  Complexity of the underlying assets or company being transacted;

c.  Size of the company;

d.  Diversity of products or services involved in the transaction;

e.  Purpose and use of the analysis; and

f.   Timing needs and staffing requirements.

The timetable for a fairness opinion can also vary considerably depending on the same factors that affect cost.  To ensure the information from a fairness opinion is available to the key decision-makers well in advance of the decision date (as well as reduce cost), it is wise to involve the independent valuation expert early in the transaction process.

This information is presented for educational purposes and is not intended to constitute legal advice. Opinions expressed are those of the author and not of Morris, Manning & Martin, LLP; see disclaimer at http://www.www.mmmtechlaw.com/privacy-policy-and-disclaimer/. Contact Bruce Wynn for more information at bwynn@mmmlaw.com