Know Your Valuation for Equity Compensation (And Avoid the Perils of 409A)

MEMBER OF PKF NORTH AMERICA, AN ASSOCIATION OF LEGALLY INDEPENDENT FIRMS © 2010 Wolf & Company, P.C.

Understanding Equity Valua2on and Avoiding the Perils of 409A October 3, 2013

Exclusively for

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Introduc2ons

•  ScoG Goodwin – Wolf & Company, PC –  Member of the Firm

–  Technology Services Team Leader

–  TCN board of directors and program commiGee chair

•  Alicia Amaral – Scalar Analy2cs –  Managing Director

–  Visi2ng Professor, Clark University and TuWs University –  CPA and CVA –  Past CFO

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Who is Wolf & Company?

•  Boston based, regionally focused

•  19 owners and 190 professionals in three offices

•  Niche focused –  Technology Services Team

•  Provide our clients with direct access to owner-‐level exper2se

•  Ability to grow with you

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Who is Scalar Analy2cs?

•  600+ valua2ons per year (50% are 409A) •  Majority of clients backed by venture capital firms and angel groups

•  Clients in virtually every industry •  Work with all of the “big 4” audit firms and countless regional firms

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Agenda

•  Overview of stock compensa2on plans •  Overview of IRC Sec2on 409A •  The who, what, why and how of valua2ons •  Q&A

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Stock Compensa2on Overview

•  Common forms of stock compensa2on –  Founders shares

•  Not really compensatory

•  Beware of retroac2ve ves2ng provisions •  How long can you issue them?

•  Other issues –  Founders coming and going

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•  Common forms of stock compensa2on –  Op2on

•  ISOs – tax treatment –  No tax at issuance –  No tax upon ves2ng –  No tax upon exercise –  Only taxable upon sale of underlying stock –  Ability to get LT cap gain tax

•  ISO criteria –  8 criteria for being considered an ISO –  Three of the more important ones

»  Issued under a formal wriGen plan »  Exercise price >= FMV of stock »  Can’t be issued to non-‐employee

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•  Common forms of stock compensa2on –  Op2ons

•  Non-‐quals -‐ tax treatment –  No tax at issuance –  Taxable income equal to the difference between FMV of the stock and the exercise

price

–  Ordinary income »  Possible addi2onal tax when stock sold

•  Factors to consider when issuing op2ons –  Tax advantages –  Less immediate dilu2on –  Keep stock in few hands for longer –  Difficult to value and account for

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•  Common forms of stock compensa2on –  Restricted stock

•  Generally common stock with ves2ng or repurchase rights

•  General tax treatment –  Taxed as the shares vest –  Income based on FV of shares on the date of ves2ng –  Ordinary income

•  Factors to consider –  Can be tax advantages

»  83(b) elec2ons

»  Start LT cap gain clock 2cking

–  FV is easier to establish for a share of stock than an op2on –  BeGer understood by recipients –  True dilu2on –  End up with more shareholders

»  Considera2on when you want to pay vendors with shares. Do you want them as shareholders?

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Overview of IRC Sec2on 409A

•  What is it? –  Part of the IRC – issued by the IRS

•  No impact on accoun2ng rules

–  Very comprehensive and far reaching impact/scope –  Regula2on governing a wide array of non-‐qualified deferred

compensa2on arrangement, including op2ons •  “Deferred compensa2on” – legally binding right to receive compensa2on in

one tax year that is or may be taxable in a subsequent tax year

–  Reac2on to perceived abuses from some earlier scandals including the op2on back-‐da2ng scandal

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•  How does it impact stock compensa2on? –  Can no longer safely issue op2ons using a rule-‐of-‐thumb or simple

board approval

–  In-‐the-‐money op2ons are imprac2cal

–  409A is forcing companies to get outside valua2ons of their stock in order to appropriately set exercise prices

–  409A is forcing companies to be more disciplined in their gran2ng process

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•  What is the worst that could happen? –  An op2on issuance intended as an EE benefit could cause tax

problems for the recipient

–  Lose the tax benefits of ISOs –  EE’s perspec2ve

•  Ordinary income in the periods in which op2ons VEST rather than when they are exercised

•  Regular tax rates (rather than cap gains) •  20% penalty •  Possible interest and penal2es for late payment or underpayment

–  ER’s perspec2ve •  Very unhappy employees!

•  Withholding obliga2on

•  ER por2on of employment taxes

•  Possible responsibility for EE’s por2on of withholdings •  Possible legal liability if sued by EE

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•  What do you as an entrepreneur need to know to stay out of trouble? –  With respect to op2ons

•  ISOs –  These have always been required to be recorded at FV so 409A really didn’t

change anything

–  But did provide some guidelines that should be followed related to valua2on

•  Non-‐quals –  Will need to deal specifically with 409A

–  General 409A compliance requirements •  Exercise price >= FMV of underlying common stock at grant date

•  FMV must be determined by the “reasonable applica2on of a reasonable valua2on methodology”

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•  What do you as an entrepreneur need to know to stay out of trouble? –  General 409A compliance requirements

•  “Reasonable valua2on methodology” must include considera2on of: –  Tangible and intangible assets –  PV of future cash flows –  MV of the stock of similar companies –  Recent transac2ons –  Appropriate premiums and discounts

•  Must be within 12 months of when valua2on is being used –  Or more frequently based on a “significant events” in the business

–  Safe Harbor Valua2on Methods •  Safe harbors are not a “silver bullet”

–  ShiWs the burden of proof from you to the IRS related to valua2on –  May only be rebuGed by the Internal Revenue Service if the company's applica2on

of the method is found to be "grossly unreasonable."

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•  What do you as an entrepreneur need to know to stay out of trouble? –  Safe Harbor Valua2on Methods

•  Independent appraisal –  Using the standard valua2on methodologies

•  Illiquid start-‐up –  Uses valua2on factors outlined in General Rule –  WriGen report –  Company less than 10 years old –  Valua2on performed by someone with significant experience, educa2on and

training in this area (>= 5 years) »  CFO »  CEO »  Investment banker

–  Reasonable expecta2on that no change in control within 90 days or IPO within 180 day

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•  What do you as an entrepreneur need to know to stay out of trouble? –  Safe Harbor Valua2on Methods

•  Binding formula –  Use formula based on book value, mul2ple of earnings or combina2on –  Stock transfers must be restricted

–  All transac2ons must use the same binding formula

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•  What are best prac2ces at various stages of development? –  Founding stage

•  Founders stock and restricted stock more frequently than op2ons

•  Using general valua2on factors is imprac2cal due to limited amount of informa2on, opera2ng history, etc.

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•  What are best prac2ces at various stages of development? –  Start-‐up

•  Friends and family or some angel financing

•  Op2on issuances start –  Companies are looking at the cost/benefit of gewng a valua2on –  Depends on your and the BODs risk tolerance

•  If using Illiquid Start-‐up safe harbor –  Document qualifica2on of person performing the calc –  Consult outside resources –  Get BOD approval and document –  For as long as you’re using the value, consider impact of events that may have

changed the value

•  Be aware of possibility of changes in control in the near term

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•  What are best prac2ces at various stages of development? –  Post-‐start up

•  Venture financing, decent amount of revenue

•  Almost all companies are op2ng for a formal outside valua2on

•  Updated annually –  Possibly mid-‐year depending on what developments take place during the year

•  More likely to have changes in control at this stage

–  Other things to keep in mind •  There has not been any case law in this area yet so how 409A will be applied

to op2ons in prac2ce is s2ll unclear

•  Modifica2ons to op2ons can trigger new 409A considera2on

•  In acquisi2on situa2on, don’t be surprised to be asked for documenta2on of compliance with 409A

Standard of Value

•  Fair Market Value –  Assumes hypothe2cal buyer

–  This is standard for 409A (per IRS) •  Investment Value

–  Assumes strategic buyer

409A ≠ VC investment

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Standard of Value

•  Fair Market Value

•  Rev. Rule 59-‐60 “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts.”

•  Important because this does not assume a strategic buyer.

This is the standard for 409A.

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Standard of Value

•  Investment Value

•  “The value to a par2cular investor based on individual investment requirements and expecta2ons”.

•  Value is different depending on synergies. •  Applies to specific buyer rather than hypothe2cal buyer. •  Investment value is usually higher than fair market value

because of synergies, and specific buyer is inves2ng for poten2al return in the future.

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Three Valua2on Methods

1. Asset Approach

2. Market Approach

3.  Income Approach

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1. Asset Approach

•  Applicable only for companies in early stage (difficult to defend, last resort if there are no other data points)

•  The Asset Approach establishes value based on the cost of reproducing or replacing the property, less deprecia2on.

•  Applied to specific assets, such as land improvements, special-‐purpose buildings, special structures, systems, special machinery and equipment, and certain intangible assets.

2. Market Approach

•  Based on the assump2on that the value of an asset (including a company) is equal to the value of a subs2tute asset with the same characteris2cs.

•  Infer value by finding similar assets that have been sold in recent transac2ons.

•  Similar to real estate transac2ons.

2. Market Approach

a)  Recent securi?es transac?on method. Based on recent transac2ons of company’s securi2es Ex: preferred stock sold to angels. Backsolve method uses OPM based on preferred rights.

b)  Comparable public co. Uses revenue and EBITDA mul2ples from companies in same industry.

c)  Comparable transac?on method. Similar to b) but uses private company transac2ons from databases such as CapIQ and Bloomberg.

d)  Industry specific mul2ples (N/A). Ex: headcount, backlog, revenue per employee, # of customers, # of users.

3. Income Approach

•  Discounted Cash Flows (DCF). •  Present value of future cash flows. •  Discount rate is based on rela2ve riskiness of investment.

•  Use this method if can reasonably rely on projec2ons.

2b. Market Example: Guideline Public Company Method

Data for similar public companies in same industry. For our example company, Venture Co, these are comparable public companies: •  Salesforce.com, Inc.

•  Concur Technologies, Inc.

•  Kenexa Corp.

•  LogMeIn, Inc.

•  Constant Contact, Inc.

For example, Salesforce has a market cap of $31B which is the “value” of the company (market cap is the stock price * number of share outstanding). Salesforce has revenues of $6.2B. Therefore, the mul2ple is $31B / 6.2B = 5

Analyst takes average mul2ples of all applicable companies.

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2b. Market Example: Guideline Public Company Method

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•  This chart for Venture Co. applies the average mul2ples to the revenue and EBITDA to calculate vaue.

•  Since EBITDA is nega2ve, it is not considered.

Steps in the Valua2on Process

1.  Take weighted average of applicable methods (asset, market or income) to come up with enterprise value

2.  Allocate the enterprise value among classes of stock

Remember that the purpose of 409A is to value common stock

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Valuation

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Step 1 – Determine enterprise value using weighted average of applicable methods (Asset, Market and Income)

Step 2: Alloca2on

•  Simply means “who gets what” in the event of an exit

•  Common shareholders get paid aWer preferred

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Alloca2on Methods

•  Current Value Method (“CVM”) – assumes value today is same as exit value –  Appropriate only if liquidity value is known as in a pending deal

•  Probability Weighted Expected Return (“PWERM”) – weighted average of various scenarios based on probability (IPO, sale, bankruptcy) –  Probability based on appraiser’s judgment

•  Op2on Pricing Method (“OPM”) – same logic as PWERM but considers more scenarios –  Probability based on Black Scholes

Op2on Pricing Method “OPM”

•  In the event of an exit, preferred gets paid first •  Common only gets if there’s anything leW over

•  Vola2lity and 2me to liquidity are important factors in determining range of outcomes

•  Greater vola2lity is beGer for common (lower lows but who cares because below zero is same as zero)

•  Longer life is beGer because more opportunity to grow

OPM

•  See Exhibit on following slide. •  Common stock only has value only if funds available exceed liquida2on preferences of preferred.

•  The OPM takes the weighted average of various exit scenarios (IPO, M&A, liquida2on) and calculates the alloca2on among the classes of stock.

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Summary

•  STEP 1 Enterprise Value $48,153,573 Less Debt (1,750,000)

Equity Value $46,403,573 •  STEP 2

Alloca2on to common $15,051,167

Divided by # shares ÷ 20,000 Price per share = $0.753

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Discount

•  Private company stock cannot be sold on the public stock markets. Analyst applies a discount to reflect this liquidity issue.

•  Discount for lack of marketability (DLOM)   25 – 45%

•  Discount for Venture Co. = 35.7% •  Price per share $0.753 less 35.7% =

$0.484 per share

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Other Points

•  Value is based on a number of assump2ons that have a material impact on the result: –  Projected cash flows –  WACC

–  DLOM

–  Comparable companies

•  Important to have a “DEFENDABLE VALUE” (IRS and auditors).

•  Important to review report for reasonableness of assump2ons. You know your business.

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QUESTIONS AND ANSWERS

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Thank You!

ScoG Goodwin, CPA [email protected] (617) 428-‐5407

Alicia Amaral [email protected] (617) 684-‐5510

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Resources

Internal Revenue Bulle?n: 2007-‐19, Applica?on of Sec?on 409A to Nonqualified Deferred Compensa?on Plans -‐ hRp://www.irs.gov/irb/2007-‐19_IRB/ar07.html

IRS Revenue Ruling 59-‐60 -‐ hRp://www.nuRer.com/media/news/media.670.pdf

AICPA Valua?on of Privately-‐Held Company Equity Securi?es Issued as Compensa?on -‐ hRp://www.wolfandco.com/tcn

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Resources

To be posted to TCN website:

•  Detailed outline and PowerPoint presenta?on •  Scalar Analy?cs – white paper, “Sec?on 409A – Common

Stock Valua?on”

Know Your Valuation for Equity Compensation (And Avoid the Perils of 409A)

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