During the past two years there has been a lot of discussion about making sure that discounted employee stock options have been properly priced relative to some unknown standard for private companies - and the new IRS penalty for getting the valuation wrong is a 20% excise tax on the misappropriated value. While this might make sense for later stage companies that are cash flow positive and potentially getting close to a liquidity event, IMHO it doesn't make much sense at all for very early stage ventures that might be years away from customer revenues.
The other bothersome aspect about these valuations are that they presume that some outside firm (typically an accounting or legal firm) will know more about how to value early stage private companies than the venture capitalists that make their living doing just that. The goal is to have a definitive source that knows how to plug numbers into a Black-Scholes spreadsheet and interpret the results. The old rule of thumb that common stock, which doesn't have the rights and preferences of preferred stock, is worth about 10% of the value of the preffered stock isn't supposed to hold up anymore in these days of CYA bureaucracy.
One of my companies recently spent about $12.5K on an outside service provider to take in a bunch of documents, answer a bunch of questions and get back a lengthy report which after all of the pain and effort concluded that the common stock price should be 10% of the preferred stock price. The funny thing is the underlying assumption that an accounting firm that has never priced a deal before suddenly can rely on a stock option value model to have a more insightful view of what a company is worth than the investors that put money into the company in an arms-length transaction. All of this defies common sense to me - but it is part of the game going forward thanks to crooks at Enron, WorldCom and many other companies. This bureaucracy amounts to nothing more than a private company tax that will affect all of us. I for one think that it is time for common sense to come back into vogue and such CYA craziness to end.
BTW - this 409A stuff was created as a part of the so called American Jobs Creation Act of 2004 - the one thing they forgot to tell us all was that the jobs they had in mind creating were those of lawyers and accountants - ones that transfer value rather than actually creating original value.
Just an opinion.
BTW - to download the outline and discount ratios of an example 409A valuation: Link
Background: In the financial world when trying to assess how risky an individual stock is, the common way to do this is by looking at the standard deviation of the price of the security. The more it varies from time to time, the higher the perceived risk. I've seen this measurement technique used the same way for Private Equity, where the Capital Account of the security is periodically updated to reflect the lower of the purchase price or the current value of the security. One of our financial advisors recently made the argument that a particular PE investment we had was actually lower risk than most of our public market stocks. I found this hard to believe and wanted to suggest some other ways of looking at Private Equity risk.
Private Equity Risk: The issue with PE risk is that the investment is not liquid. Its value is usually the lower of the acquisition cost, or of the most recent financing transaction. There is an inherent bias to try to keep from writing the value of investments down, since that would signal defeat and also invite within a PE firm, so more often than not, the value of a PE investment stays on the books at some arbitrary value for years. The fact that is doesn't have much, if any, standard deviation is not a measure of reduced risk, but instead just a reflection that there isn't a market for these securities and the valuation technique is sometimes inefficient.