Basics of the 409a Valuation Report

If you have been searching for a specific template for the 409A valuation report, then you need to know that there is “no specific template” for the valuation. It was in 2007 when the section 409A was introduced and since then, people have worked hard towards satisfying the law that the IRS has put up. That is even the IRS has not created a definitive guideline of how the 409A valuation report should be.

Due to this, there are many different templates that you might come across. But you might find a few specific subheadings or parts that are the same in all of these reports. The standard of the content and quality of the 409A valuation report is mostly driven by the large accounting firms in the country. As templates have evolved since then and the AICPA Practice Aid has become the handbook for many firms performing 409A valuations.

In this article, you will learn all about the basics of the 409A valuation report. But before we can get into the parts of the report, let us understand what a valuation report is, and when you can get the value and work with it.

What a 409A Valuation Report Is Supposed to Do?

A great 409A valuation report should be like any other great piece of quality research, where it opens the mind of the readers to possibilities that you have considered. Placing a dollar value in the eyes of the owner for this company isn’t what the quality valuation is about. Nor is the valuator’s job to search for the value in every corner, event, data or hidden matters that would affect the value of the company.

So then, what is the job of an appraiser? The appraiser should offer a third-party an object opinion of what would actually happen in case the subjected business was put on sale in the market. A business owner can also get an estimated value with their own research. But if an appraiser is working on it, then the business owner would learn that there is a range of values along with the compilation of opinions based on various methods of valuing those assets.

That is what the 409A valuation report is made of. To be frank, the 409A Valuation Report would have many pages. But to help you know the main information on these pages, the following is a detailed analysis of what would be there in it:

Engagement Overview

This is the very first part of the 409a valuation report that shares the details regarding safe harbor protection. Safe harbor protection comes to a company when it has an independent and qualified party perform the 409A valuation. The engagement overview defines everything about the relationship between the company and the third party.

It acts like a cover letter that has all the key information about the valuation of the company and the company background. In short, it holds the details of where the company is located, the contact information, and its logo to give a little introduction about the company. In addition to this, you would also find an important date. See if the date is the date of when the report was turned over or if it is just the official date of the valuation. It is usually the date on when the valuation is done.

Note: It is important that you notice all the dates mentioned in the 409a valuation report. Every reader should be clear about the various critical dates that show up in the valuation report. In fact, the valuation date is an important part of the valuation report. This is because if the report is being used for tax purposes or in case it would eventually become an evidence in a lawsuit or divorce action, the time sensitivity of the report is very important and is based on the different situations of the case.

Company Overview

People reading the report might already know all about the business, but they would want to see how the valuation professionals describe the company in the 409A valuation report. The readers would want to know what the valuation professionals know about the company. And that is why under this section, an overview of the company is provided.

In short, this section has the following details:

• Company’s Overall Financial Performance: This normally contains the one-year summary of the financials of the company. But the report also makes a lot of references to the financials of the company over a period of multiple years. It can have a chart of the financials of the company for a three-year to a seven-year period.
• How the Financial are Normalized/Adjusted & The Purpose: It is common for 409A valuation professionals to adjust the financial figures for facilitating specific valuation methods. Hence, the report needs to show how to adjust these things along with the reason as to why the adjustment was made. These adjustments are one-time adjustments for things like a rare lawsuits or capital expenditures from a fire or flood.
  These adjustments are normally derived from control adjustments. To explain simply, running a privately held company allows you to add some expenses “through the business.” For instance, there can be a family member who is on the payroll and isn’t working for the company.
  When maximizing the deductions for any tax purposes, these kind of control adjustments are common as long as they are being used as per the tax code. But when it comes to the valuation of the company, the owners need to be ready to open their books and show the adjustments.
  And if people are misusing the idea, they would need some time to clean up their financials before they can have the 409A valuation performed. All in all, the report would also show all the financials that have been adjusted under the company’s overview.
• Compensation of the Owner: Assuming that the company is a small with just one owner, the owner’s compensation section is the place where the readers would be able to see the top salary of the company benchmarked against that of the executives from similar sized-companies in the same industry. In case the salary is above the range, it can be valued outside the expense side of the normalized financials of the company. And in case the business changes hands, the new chief joining does not have to be paid the same.
  In companies that are much larger, the benchmarking of the salary would be broader. And if the owner isn’t paying themselves a fair market wage in relation to the size of the company, it would indicate a poor stewardship of the company acquirer. And is an important reasons to analyze the compensation in the company. This too would be placed on the 409A valuation report to explain all about the company better.

Market Overview/Overview of the economic environment

Anyone can read about the general state of the economy of a business, but only a valuation professional would know how to apply the macro view to the micro world of the business under a valuation. In short, when the world economy suffers from bad times or experience good times, the valuation professionals cannot ignore this. It is important for them to pay attention to what the business is doing and who they are competing with.

Hence, in the 409A valuation report, there would be notes on how the economy is playing in the same sector of the business and in general. Here are some of the things that would be described in the section:

• GDP: The GDP (Gross Domestic Product) is the total value of all the services and goods that are produced in one year. This helps in measuring how free the business owners feel in investing in the company to increase production.
• Interest Rates: The Federal Reserve Board lets people in the world know about the level of the economy, as this helps in deciding interest rates. This is added in the valuation report to allow the owner to know how much credit there would be when they are about to borrow in a particular climate.
• Exchange Rates & Commodity Prices: For companies that use raw materials, it is important for them to know how the costs of raw materials would affect the cost of production in the area of business. Additionally, the exchange rates can have an impact on the company’s operations overseas. And the valuation professionals need to know all about the state of these and how it would affect the valuation of the company in different situations.
• Political & Policy Considerations of the Government: The policy & political considerations are important and it is researched to see how it would affect the business in question in case there is any change in tax, regulatory and energy policy in the country.
• The State of Business Financing in General: Almost all businesses need to have a good relationship with credit. And while valuation professionals value the business, they need to keep the complete credit environment in mind and give an overview about it in the 409A valuation report.
• The State of Capital Spending: Capital spending is an important aspect for the growth of the company. The report needs to show if the company would be spending a lot to make investments in the business.
• Key Measurements: Based on the industry and size of your company, valuation professionals would follow the market indicator to measure how your sector of the economy is doing and add in the report.

Valuation Methods/Valuation Theory Overview

Talking about the method that was used after seeing the numbers is a bit off, but the owners usually want to see the dollar figure first. This section would talk about the features of the company and the valuation methods of the company. Here is what you would find in it:

Valuation Key Assumption

Whatever the owner sees here would be called the valuation key assumptions. Even though the business owner is thinking of selling their company, the valuation professionals see the assets of the business in a very different way. And they make an assumption based on what they feel is the best way to monetize the assets. Here, the professionals would tell the value of the assets when sold together and when sold separately. They would also let the owners know which idea is better.

Industry and Competitor Analysis

It is very important for the valuation professionals to display the truth about the state of the industry that the company is in on the 409A valuation report. This is important for valuing the company since the professionals would have to understand what the leaders in the industry are doing, what products they have, and what the growth prospects are.

For getting this story, the professionals use a host of public and private company data, news stories, database material, and a host of public and private company data to create this. This part of the report would show the comparisons of the revenue and the operating profit growth of the industry for a specific period of time. It should show whatever is appropriate to the industry, so that the person reading it can get an idea of what the next 3 or 5 years would look like in their industry and company.

Other than this, there are some other things that you might find in the section of the industry outlook. They include:

• Growth Probability: The report would display the details on where the company stands on the path towards growth. But to be sure that the details are right, it is advised that the reader should also have some knowledge on the industry and its growth prospects.
• Benefits & Potential Threats for the Overall Industry

A few of the valuation firms use their own formulas to analyze the issues, while others use the news and other sources to follow the industry closely. In fact, one is not necessarily better than the other.

Enterprise valuation/Valuation of the Company

Once everything about the industry has become clear, the next thing that the reader wants to find is the final valuation of the company. This is the section that shows it. And it is displayed as – The value of ABC Inc is $3 million based on the weighting of income and market valuation methods.

Here, you need to note the part “weighting of income and market valuation methods.” This tells the methods that were used to value the company and not every company would have the same kind of approach mentioned in the 409A valuation report. The section also reports the following details:

• Limiting Conditions & Assumptions of the Company: This part shares the assumptions and conditions on which the 409A valuation report is based on. You would find a statement in the valuation report that describe the following:
  • The company’s property is clear of liens.
  • The legal description & title of the company are correct.
  • Notes on the illustrative material.
  • Any environmental effect statements that are relevant.
  • Factual Information from other sources are reliable.
  • Licenses obtained to run the business has been obtained.
  • The ownership & current management has been verified & declared responsible for the business.
  • There is evident compliance with the land and zoning use regulation.
• Executive Summary: This is a summary that lets the readers know all about the critical points of the 409A valuation process.
• Purpose of Valuation: In this section, the purpose of the valuation is mentioned along with the breakdown in the ownership of the company.
• Standard of Value: This section shares the standard of value that was used to create the valuation. The intrinsic value, strategic value, fair value and fair market value all give different values in the end based on the kind of business being considered. The standard of value assists in determining if the business owner has to take various discounts which includes discounts for lack of marketability and lack of control. It should also be noted that in case the reader has had the company valued before too, the methods & standard used the next time would not be the same.
• Valuation Date: This is an important part of the report as it gives a date from when the reports validity begins. The date is decided by the valuation professionals and the owner before the process begins. It is also the time when the professionals freeze the financials and conditions of the company.

Equity Allocation

After all the valuation methods have been tried out and the right method has been selected, the professionals would then allocate the value of the company that was determined to the different classes of shares. And when this is done, the fair market value of 1 share in the common stock is eventually determined through this.

Summary and Results

This is the section that lets the readers know about the various valuation methods that were tried out and the conditions that helped choose the suitable method. You would find the following information in the 409A valuation report under this section:

• Methods Examined & Rejected/Accepted: Under this, you would find all about the various methods and approaches that were considered and rejected along with the reason. Along with that, you would also see the methods and approaches that were selected and the reasons why they were selected.
• Explanation of weighting each valuation method: Here, weighting is the indicator of importance. A few of the valuation methods weight other methods to reach a final value. Plus, not all reports have this part as some appraisers do not weight the valuation methods while some do.
• Discounts & Premiums: This is the adjustments that are made to value. It can be done during the process of the valuation of the company. It can also be done after the value has been determined.

Certification

After all this, the 409A valuation report authors certify the report with their credentials. A valuation report that is certified assures the IRS, auditors, and management that the company meets the safe harbor requirements. Hence, ensure that your report has this.

Appendix

This part shows the information about the expert who worked on the valuation along with the information on the valuation firm the person works for. It would also have notes on the charts and exhibits along with other descriptive materials. A few of the valuation firms also add in a list of the glossary in the appendixes to ensure that everyone understands all the termed mentioned in the 409A valuation report.

Conclusion

In the end, it is highly recommended that companies use a qualified, independent valuation professional or firm to perform their 409A Valuation and get a proper 409A valuation report. And if you feel we are worth a try, we would be happy to help you out.

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