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