Valuing private equity interests can be challenging even in the best of circumstances. Problems compound when the valuation is required in a divorce setting.
Fundamentally speaking, private equity is capital invested in a company or other entity that is not publicly listed or traded. Typically, private company interests can include any or all of the following: direct ownership interests, stock options and warrants, carried interests, or diversified investments through venture funds. Because the value of these private equity interests cannot be readily obtained from active trading in the public market, estimating value requires specific expertise and information. Fortunately, developments in federal tax law have brought an increased focus on the valuation of private equity interests. On center stage is the 409A valuation.
Section 409A was added to the Internal Revenue Code, effective January 1, 2005, and has evolved substantially over the last 16 years. A 409A valuation is an offspring of IRC Section 409A and is meant to provide an independent opinion of a company’s total value. The birth and now-common use of the 409A valuation is not a focus of this article. Suffice it to say, for a privately held company, a 409A valuation is the only method startups can use to grant stock options to their employees on a tax-free basis.
If you are going through a divorce and your soon-to-be-ex (“STBX”) holds private equity interests, your attorney should immediately obtain all existing 409A valuations related to those interests. Moreover, the 409A valuation will provide a substantial amount of information about the company, its expected future prospects, and the fair market value of its common stock. The reports additionally contain assumptions used by the company’s independent appraiser and may provide a foundation for estimating the value as of a date pertinent to the divorce proceedings.
While access to 409(a) valuation reports will not eliminate the need to engage a valuation expert, since other factors such as controlling or non-controlling interests and illiquidity must still be addressed, it will reduce the time and cost required by your expert.
Additional information to gather for your expert through interrogatories or the deposition of your STBX include:
- Risk of investment — What is the likelihood of achieving the projections? Is there the potential to lose all or part of the investment?
- Amount of original investment
- Additional investments
- Ownership percentage — What is the ownership percentage after the original and subsequent investments?
- Distributions received
- Future obligations — Will the investment require any future performance or funding?
- Time horizon — What is the time frame for the potential to be realized and liquidity to be achieved?
- Projected return on investment
- Probability of achieving expected return
- Current status of project
- Rights of investor — Does the investment include voting rights?
- Restrictions on transferability of ownership
- Liquidity — When will cash be received for the ownership interest?
- Status of tests, trials, government approval, permits and authorizations
- Governing Provisions of Stockholder’s or Partnership Agreements
- Offers to buy or sell ownership interests in the entity
- Exit Strategies (IPO, private placement, etc.)