5. Dual Purpose is de rigueur

The conflict (and resolution) of competing tax and GAAP standards of value.

Occasionally, we get asked to opine on the state of our industry and prevailing best practices. We’re in a fairly good position to speak to the issues, being at the crossroads of compliance as we are. For while our clients are a self-selecting group, purposefully offloading 409A-related risk, we have spoken to several hundred attorneys, investors and entrepreneurs across the country about these very issues, and we have a good feel for what "everyone else" is doing. Not everyone is falling in line, but aggressive and conservative practices are beginning to converge on a middle ground.

The complicating factor that has recently emerged in the world of 409A is its collision with SFAS 123R. By “recently” I mean late 2006. By “complicating factor” I mean it turned the IRS’s 409A into a sideshow while the FASB’s 123R requirements are having their way with the valuation community. By “collision” I mean the FASB requirements are steamrolling over the lumpy world of cottage 409A valuation providers.

Here’s what’s going on. The FASB long ago adopted a redefined set of valuation standards using a blank slate. These standards are significantly different than what is promulgated by the IRS, and they are being formalized and more clearly codified under Statement 157. Interestingly, these standards are newly being enforced by the audit community, with sharp teeth. From the Big Four on down, a new strict adherence to SFAS 157 is taking hold.

Aye, there’s the rub of it. As you know, IRC 409A and SFAS 123R both apply to the calculation of the underlying value of stock options. 409A follows the IRS standard of value called Fair Market Value. By contrast, SFAS 123R is a GAAP standard, so any valuations used to calculate stock option expense according to 123R must adhere to the FASB standard, known as Fair Value defined under SFAS 157.

Guess what? It turns out that many valuations of stock options were conducted during a period after the advent of 409A and before many practitioners foresaw a collision with 123R. Many companies that acted in good faith are now being penalized, in a manner of speaking, because their 409A reports are being cast aside by their auditors. It's true -- auditors are often requiring new valuations to be conducted for the same time period under a different valuation standard. Thus, many of these companies will have two valuations of common stock for a given date: one conducted contemporaneously under IRS standards; and another conducted retrospectively under GAAP standards. Talk about teeth gnashing.

To minimize the pain of this complicated collision, we are no longer issuing tax-only compliant valuations. Instead we have put a new emphasis on our dual-purpose reports, which have always been compliant with both IRS and GAAP standards. The dual-purpose valuation is a significantly more time consuming report to create, and we feel strongly that this added care is highly valuable to our clients.

To every CFO that presents him or herself, I repeat the following warning: make sure your valuation provider can guarantee four things:

1. Adherence to USPAP standards. USPAP has many strict and necessary requirements. One important requirement is that no junior analysts may be involved in creating a USPAP-compliant result.


2. Adherence to Fair Value accounting standards as well as satisfaction of Fair Market Value tax standards, resulting in a dual-purpose report.


3. A strong history of valuations having passed financial audits, especially by the Big Four.


4. “Near and clear” exposure to the SEC.

If your valuation provider can satisfy this checklist, you should be in good hands, notwithstanding the fact that it’s always a good idea to check references.