409A is a section of the Internal Revenue Code. A 409A appraisal provides a “safe harbor” from punitive taxation of options issued to employees. An appraisal provided for financial reporting in accordance with ASC 718 “Compensation – Stock Compensation” may be referred to as a “409A appraisal,” even though tax reporting and financial reporting are different.
Once a year, unless there is a value-changing event, such as an equity financing.
A company may finance its assets with capital raised from its investors and borrowed money. Equity value is the value of ownership interests. The market value of invested capital (MVIC) is equity value plus debt. Enterprise value is the value of MVIC less cash. It corresponds to the value of the company’s non-cash assets. To illustrate, in a company with an equity value of $100, $25 in debt and $30 in cash, the MVIC is $125, and the enterprise value is $95.
When a company raises equity capital, it sells a percentage interest in its equity to investors. The company’s pre-money value determines what percentage is sold for a given amount of investment. The post-money value is the sum of the pre-money value and the amount raised. To illustrate, a company that sells a 25% equity interest for $5 million has a pre-money value of $15 million and a post-money value of $20 million. The amount raised ($5 million) represents 25% of the post-money value.
When a company sells preferred shares, post-money value is calculated as the product of the shares outstanding after the financing times the preferred price. Typically, common shares have fewer rights than preferred shares, so the common is worth less, and therefore equity value is less than post-money value.
Post money value = All shares x preferred price
Equity value = Common shares x common value + Preferred shares x preferred value
The OPM is a method for allocating equity value between preferred and common shares. It treats each class of equity securities as a call option on the equity.
Options are valued using the Black-Scholes formula. If the value of the option is known but one of the inputs to the Black-Scholes formula is not, it is possible to “backsolve” to the value of the input. In a venture-backed company, if the preferred price is known, it may be possible to backsolve to the value of the company’s equity.
A discount rate is used to convert future cash flows to present value. It represents a target rate of return, such as the weighted average cost of capital. A discount for lack of marketability (DLOM) is an adjustment applied to the value of an unregistered security. A share of publicly traded stock is worth more than a share in an identical but private company. The difference is represented by the DLOM. Selecting the appropriate discount rate and DLOM is part of the appraiser’s craft.
It’s not just a number. It is a well-reasoned argument that applies accepted practices to support a conclusion of value. Without that support, the “opinion” is vulnerable to challenge. Every appraisal delivers an opinion as of a certain date, and the appraiser is required to consider all relevant information as of that date. The interest to be valued (for example, a single share of common stock) is precisely defined.
The Treasury regulations for application of Section 409A list factors to consider: the value of tangible and intangible assets; the present value of future cash flows; the market values of stock in similar corporations; and recent arm’s length transactions involving the sale or transfer of equity interests. Control premiums and discounts for lack of marketability should be considered as well. These factors are to be included “as applicable.”
The cost of an appraisal is the sum of the appraiser’s fee and the auditor’s fee for reviewing the appraisal. If the appraiser’s fee is low, but the quality is poor, the cost of the audit goes up. That can be a very expensive appraisal.