Are We Burning the Candle at Both Ends?
Venture capital firms continue to wrestle with Standard 157 of the Financial Accounting Standards Board (FASB), now codified as Accounting Standards Codification Topic 820, which establishes guidelines for determining the fair value of assets and liabilities on financial statements.
As VC firms generally invest in early stage start-ups, the underlying concepts of Topic 820 are often difficult to apply or frequently considered irrelevant. Most VC firms have the in-house expertise to conduct these valuations internally, which saves money and, to some extent, influences the outcome. But an internal effort may consume much of the CFO’s time.
Doing it different
There is no reason to think that such in-house valuations are unreasonable. But, the fact that they often lack defensible documentation for the input factors exposes VC firms to possible regulatory scrutiny.
We believe that VC firms have a ready, yet often overlooked, source of verifiable valuation information to support their Topic 820 compliance: the Internal Revenue Code Section 409A valuations of their portfolio companies.
Section 409A requires that when private companies grant stock options to employees, those options be granted at a strike price equal to or above its fair market value to avoid income tax penalties.
VC-backed privately held companies generally hire third-party appraisers to determine this fair market value. This saves time and money, but more important, transfers the risk of facing auditors to appraisers who are motivated to protect themselves through careful assumptions and value derivations.
A historical perspective
A brief discussion of the concept of “fair value” is appropriate here. The fair value standard as defined for financial reporting purposes before Topic 820 defined it was almost identical to the fair market value standard set by revenue rulings for Section 409A purposes. For all practical purposes, the two value standards were considered consistent with each other.
It’s true that the Topic 820 definition introduced or refined some concepts (e.g., exit price, most advantageous market, and inputs hierarchy), but we believe that when analyzed in light of the nature of the assets in question (i.e., investments in illiquid privately held start-ups), the perceived differences are not significant enough to cause any material differences in the conclusion.
The problem area we foresee is that portfolio companies understandably have a bias toward a conservative valuation to make stock options attractive to employees, while VC firms are inherently inclined to have relatively higher valuations.
There is, therefore, a perception that the Topic 820 and 409A valuations derived for the same portfolio company for the same time period vary significantly. This could lead to potential compliance or corporate governance issues in the future.
A potential win-win
Nevertheless, we encourage VC firms to examine their portfolio company 409As closely. We predict they will find much information based on rigorous independent analysis that they can use to comply with Topic 820.
VC firms would do well to establish an internal process to tap into the 409A valuation resources of their portfolio companies. By doing so, they may improve portfolio oversight. Perhaps more important, VC firms may also be able to use 409A input data as a reliable hedge against potential Topic 820 noncompliance liabilities that may arise because of inconsistent value conclusions derived for different purposes but for similar value standards. Why burn the candle at both ends?