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Importance of a 409A Valuation for Any Stage Business

May 17, 2016

Ever since 409A valuations became a topic a decade ago, the IRS seems to have often be top of mind for law firms and their clients. We routinely have new clients referred to Armanino by their lawyers and they know they're supposed to have a 409A valuation completed, but they're often not particularly clear on why and how that valuation even matters. We often hear the common question "how many companies find themselves in trouble with the IRS due to 409A compliance issues?" The reality is that the IRS really just started their Compliance Initiative Project in 2014, stating that they "will try to limit the scope and burden on taxpayers by limiting [the IRS's] inquiry on the top 10 highly compensated individuals.

One of the results of this relatively limited enforcement in 409A compliance has been that many private companies – and to some extent even some of the lawyers who advise them – have embraced a somewhat cavalier attitude towards 409A compliance and specifically the defensibility and quality of the reports. Given the lack of IRS enforcement, it is not surprising that early stage companies are sometimes tempted to use a lower cost provider to just get the valuation done and out of the way rather than seeking a more reputable, established firm because of a misguided perception of low risk.

The fact of the matter is that the IRS is not going to be particularly interested in auditing 409A compliance for early stage companies that are not yet profitable and often haven't even reached the revenue stage. Later stage companies typically have a different approach to 409A valuations than early stage companies because their financials are audited. Knowing 409A reports will be scrutinized by their audit firm, a more mature company definitely needs to ensure their 409A valuations are done right so they'll sail through an audit quickly and smoothly. These later stage companies focus more on the quality of a service provider, rather than attempt to cut corners on getting the 409A valuation out of the way.

Many early stage companies – "We're early stage, just completed our Series A, and we're not audited." – tend to want to invest more in product development, marketing, sales, etc. rather than compliance. An understandable desire for an early stage company. However, poor 409A compliance can have unintended negative consequences a few years down the line, if not sooner.

It should be no surprise to anyone that the vast majority of start-ups never make it to Initial Public Offering (IPO) and the most common exit is an acquisition. Those acquisitions are not always targeted at mature companies, but often targeted at relatively young companies, sometimes pre-revenue and in some cases within 18-36 months of inception. Often, the acquiring company is a Fortune 500 company employing some of the top accounting professionals in the industry for their own audits causing sudden and tremendous scrutiny of the young company's compliance and accounting practices during the due diligence process. This scenario spurs the early stage company into a mad rush to clean up their accounting and compliance issues in an effort to get everything in order for the potential acquisition.

Arguably, the greatest financial penalty of poor compliance is the weakened negotiating position of the company being considered for acquisition. The impetus for the acquisition may be a product or technology that the acquirer finds very attractive, but no company is too keen on acquiring an accounting and compliance mess with potential future liabilities. The temptation to take initial shortcuts or bypass proper compliance practices can have far-reaching and sometimes unexpected consequences for an early stage company. Ensuring your 409A valuation is solid and done properly helps mitigate risks for businesses.

Learn more about Armanino's Valuation team and find more details on how to ensure your company's compliance needs are handled properly from the start.

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