William D. Cohan, writing in the New York Times’ DealBook, characterizes the third-party valuations of private companies under Section 409A of the Internal Revenue Code as Silicon Valley’s “dirty little secret” and a “shell game.” Especially in the aftermath of the financial crisis, there has been plenty of populist rhetoric about practices in the business world, and much of that criticism has had basis in fact, but this take on 409A valuations seems awfully strained.
As described in Cohan’s article, Section 409A and the related rules require that companies obtain independent valuations in connection with their issuance of equity-based awards to employees, and failure to comply results in tax penalties. Cohan details the fact that various service providers charge significant fees to undertake these valuations, using words like “supposed” experts to make the whole enterprise seem like a racket, but the reality is that the rules do exist, and these valuations have to be done. If it was possible for just anyone to make up a valuation for a bargain-basement fee, heck, I would consider doing it as a side gig from my legal work. But the rules actually go into detail as to the required qualifications for firms providing these services. Cohan notes in the article that the SEC would not comment on these practices, but this is really more of an issue of tax law than securities law. What constrains companies and their hired valuation help from simply making up numbers out of thin air is the fact that their decisions are subject to later IRS scrutiny and sanctions.