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 differently
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.
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