IRS begins Section 409A audits?

According to a release by Jones Day (http://www.jonesday.com/newsknowledge/publicationdetail.aspx?publication=6738), the IRS has sent Information Document Requests (IDRs) to companies that fall under Section 409A. The 409A section, as we all know, was enacted in 2004 (signed into law as part of the American Jobs Creation Act of 2004 and became effective Jan. 1, 2005) but took effect for most private companies beginning 2007. It appears that in 2010, the IRS will scrutinize this section more, despite some CFO organizations calling it the worst tax and citing plenty of confusions with the code.

Due diligence in 409A valuation reports

I wanted to write this note because we are receiving projects/reports where lack of communications between appraisers and companies is leading to erroneous reports. In a 409A valuation report, the emphasis is always on due diligence and supportable data/conclusions and less on the tools to arrive at the final discounted value. It takes industry experience and an understanding of the risk factors to ask the right questions, document them and then weigh the various approaches that contribute to the final decision. Recently, a firm came to us with a report that was rejected by an audit firm. This firm had used outsourced analysts in a foreign country (visible from the way the report was written), who had not communicated properly with their clients and ended up using unjustifiable calculations. We had to redo the entire analysis and report and ask the right questions. In fact this firm does not take into account the post money valuations at all in their assessment of a firm's value, most probably because the overseas analysts probably did not know of such evidence. The irony is that this firm advertises widely on Google touting its discount pricing and use of overseas analysts. A review of their reports showed that they always used only one approach, going completely against the methods suggested in the AICPA practice guide. Further, their volatility calculations were arbitrary and lacked support. Forecast parameters were not validated against comparable peers' ratios. In one of their spreadsheets, the fair market value for common stock was pointing to the preferred stock cell. I would advise clients to exercise caution when procuring valuation services from companies that cannot defend them or cannot make available their principals for audit. If your auditor does not accept your valuation, you may end up having to get a new one done at additional cost. Today technology exists to provide affordable valuations using a fully staffed team in the US. We strongly recommend that US firms use US based appraisers for their valuation needs. Accuserve uses a fully staffed US team to provide valuation services, yet our costs are very comparable to companies that outsource them.

IRC 409A tax court cases

With some of the first court cases appearing in the 409A area (See Slater vs Commissioner of Internal Revenue at http://www.leagle.com/unsecure/page.htm?shortname=in20100111d35), it is time to assume that the IRS is auditing 409A provisions and associated valuations. It is in this background we have to note the mushrooming of firms in this area. It has come to our notice that several firms are getting the work done overseas and in fact there are foreign firms offering these services in the US. One of the main issues with working in an outsourced manner is the lack of an expert that can be relied upon as expert testimony in such cases. As we all know, the IRS imposes penalties if the tax liabilities have not been measured under a fair market value standard under the 409A regulations. Given the size of IRS penalties and the nature of add-on penalties, it is important to work with US based firms that have a good understanding of the legal systems here, an understanding of what it takes to be an expert witness and have solid relationships with audit firms. We have been concerned a bit by the outsourced model, where foreign analysts compute and calculate the valuations with no experts out here to back such values. While costs are a major factor for start-up companies in getting this work done, firms such as ours have used technology extensively to negate the cost savings arising from an outsourced model. Given that we fully back our valuations and our principals have been subject to audit processes,  we believe that we offer the best possible affordable service in this area.

Lets play the ratings game!

Now that the Goldman imbroglio threatens the forward economic movement again, it is important that we ask plenty of questions. While Goldman is being sued for acts of negligence, why arent the rating agencies being sued? 93% of sub-prime mortgage was downgraded from AAA to junk status at the beginning of the crisis, yet the agencies get to have immunity. If the rating agencies cannot be sued, why was it set up that way? There are solutions going on about how ratings agencies need to change their business model and one of the proposed models looks very much like what the FHA did with how it chose appraisers. The FHA got the lenders to use an independent business to farm out the appraisals, eliminating the bias in choosing a particular appraiser. So, the advocates of this theory now want the SEC to step in and choose one of the appraisers of these securities. One more thing: what were the bond investors like PIMCO doing? Are'nt they supposed to be doing their homework in assessing the fundamentals of their holdings? They too have an army of analysts, you know. Relying on the AAAs issued by the S&Ps of the world only got them shot. Yet, they refuse to complain about the rating agencies.
Taking this a bit further and a thing I have suspected most, are our personal credit rating agencies. I believe this system is rigged as well in favor of the banks. I have looked at some statistics dished out by the personal credit rating agencies and the numbers do not add up. Numbers such as the risk rating and the number of consumers above or below your risk rating do not conform to what we know about what is going on in the economy. Though, we pay for accessing these ratings, the model seems to be skewed in favor of the banks. So, no matter who pays, there seems to be biases built into the credit rating system.
How do you solve this? Can we build a truly efficient, competitive market that cannot be gamed? It is up to us to take control of our finances. Large institutional funds, remember, are just aggregators of your money and then unwisely invest them into so-called AAA rated sub prime securities on the advice of an investment banker, who shorts those holdings at the same time. Wake up investors and ask questions! That truly seems to be the solution to me,

When negotiating term sheets, should a founder just focus on anti-dilution clauses?

Many founders are focused on whether or not to include anti-dilution clauses. What they fail to realize is that the funding structure is more complex than just dilution. A VC can invest in a way that it may look like you are holding 50% of the company's common stock, but you may get allocated a much lesser value. For instance, if the VC negotiates a 2X liquidation preference with a full participating feature with a cumulative dividend pay out of 8% per year (and barring dividends to be paid to the common stock holders), the common stock despite having a 50% position may in reality get less than 10% of the company's value at exit. They can also add warrants that currently wont dilute common but on exercise will (it is just a delay effect - makes the founder's stake larger than it actually is). All this mean your stake has been effectively diluted through a variety of means and not just direct dilution. We use random scenarios to prove what a founder will get in different negotiating situations. There are also pay-to-play clauses which also affects common stock value. If you have anti-dilution protections in there, the VCs will simply negotiate a stricter participating preferred stock. The only way to negotiate is to go in with a game theory based model and keep plugging in VC numbers in a Monte Carlo random simulation scenario to see if the founders have a decent RoI under a random exit scenario.

I strongly advise that founders consult with experts like us to see if VC terms are fair game. We can calculate this using prevailing peer volatility considerations. If you are returning a VC more than the average return a VC expects, you are really not negotiating very well. We have reviewed so many SPAs where dilutions have been achieved through several creative terms. The VCs are good at this - they have analysts on their side. Founders need to get someone on their side as well.

We know of companies where the VCs had so many clauses that founders had to renegotiate their stakes when they realized that, in the middle of their  company's development, they wont even get 1% of the return. We had to go in and create a new preferred security class for the founders instead of the usual common stock, just to keep the RoI fair and the morale high.

Series A and Series B term sheet negotiations are critical to realize a fair RoI the founders. Fortunately, today, we have decent models to do this.