Know Your Valuation for Equity Compensation (And Avoid the Perils of 409A) - More Detailed Presentation

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

Know Your Valuation For Equity Compensation (and Avoid the Perils of 409A)

Exclusively for

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Introductions

• Scott Goodwin – Wolf & Company, PC– Member of the Firm– Technology Services Team Leader– TCN board of directors and program committee chair

• Alicia Amaral – Scalar Analytics– Managing Director– Tufts University, Entrepreneurial Finance– CPA and Certified Valuation Analyst, CVA– Past CFO

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Who is Wolf & Company?

• Boston based, regionally focused

• 19 owners and 200 professionals in three offices

• Niche focused– Technology Services Team

• Provide our clients with direct access to owner-level expertise

• Ability to grow with you

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Who is Scalar Analytics?

• 600+ valuations per year • 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 compensation plans• Overview of IRC Section 409A• The who, what, why and how of valuations• Q&A

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Stock Compensation Overview

• Common forms of stock compensation– Founders shares

• Not really compensatory• Beware of retroactive vesting provisions• How long can you issue them?• Other issues

– Founders coming and going

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• Common forms of stock compensation– Option

• Incentive Stock Options (“ISOs”) – tax treatment– No tax at issuance– No tax upon vesting– 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 written plan» Exercise price >= FMV of stock» Can’t be issued to non-employee

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• Common forms of stock compensation– Options

• Non-quals (“NQs”) - tax treatment– No tax at issuance– Taxable income equal to the difference between FMV of the stock and the exercise

price– Ordinary income

» Possible additional tax when stock sold

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

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• Common forms of stock compensation– Restricted stock

• Generally common stock with vesting or repurchase rights• General tax treatment

– Taxed as the shares vest– Taxable amount based on FV of shares on the date of vesting– Ordinary income

• Factors to consider– Can be tax advantages

» 83(b) elections» Start LT cap gain clock ticking

– FV is easier to establish for a share of stock than an option– Better understood by recipients– True dilution– End up with more shareholders

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

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Overview of IRC Section 409A

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

• No impact on accounting rules– Very comprehensive and far reaching impact/scope– Regulation governing a wide array of non-qualified deferred

compensation arrangement, including options• “Deferred compensation” – legally binding right to receive compensation in

one tax year that is or may be taxable in a subsequent tax year– Reaction to perceived abuses from some earlier scandals

including the option back-dating scandal

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

board approval– In-the-money options are impractical– 409A has forced companies to get outside valuations of their

stock in order to appropriately set exercise prices– 409A has forced companies to be more disciplined in their

granting process

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

problems for the recipient– Lose the tax benefits of ISOs– EE’s perspective

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

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

– ER’s perspective• Very unhappy employees!• Withholding obligation• ER portion of employment taxes• Possible responsibility for EE’s portion 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 options

• 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 valuation

• 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 application of a reasonable

valuation methodology”

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

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

» Together, referred to as the “General Rule”

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

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

– Shifts the burden of proof from you to the IRS related to valuation– May only be rebutted by the Internal Revenue Service if the company's application

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 Valuation Methods

• Independent appraisal– Using the standard valuation methodologies

• Illiquid start-up– Uses valuation factors outlined in General Rule– Written report– Company less than 10 years old– Valuation performed by someone with significant experience, education and

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

– Reasonable expectation 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 Valuation Methods

• Binding formula– Use formula based on book value, multiple of earnings or combination– Stock transfers must be restricted– All transactions must use the same binding formula

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

• Founders stock and restricted stock more frequently than options• Using general valuation factors is impractical due to limited amount of

information, operating history, etc.

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

• Friends and family or some angel financing• Option issuances start

– Companies are looking at the cost/benefit of getting a valuation– Depends on your and the BODs risk tolerance

• If using Illiquid Start-up safe harbor– Document qualification 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 practices at various stages of development?– Post-start up

• Venture financing, decent amount of revenue• Almost all companies are opting for a formal outside valuation• 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 options in practice is still unclear• Modifications to options can trigger new 409A consideration• In acquisition situation, don’t be surprised to be asked for documentation of

compliance with 409A

Standard of Value

• Fair Market Value– Assumes hypothetical buyer– This is standard for 409A (per IRS)

• Investment Value– Assumes strategic buyer

409A ≠ VC investment

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Investment Valuation for Start-Ups

• Discounted Cash Flow???• Berkus• Bill Payne Method• Risk Factor Simulation• Venture Capital Method

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David Berkus Method

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$500k for each• Good idea• Prototype

• Quality Team• Quality Board• Initial Sale

Value $0 to $2.5 Million

Bill Payne Method

FactorManagementSize of Opportunity/MarketProduct/ServiceSales ChannelsStage of BusinessOther

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Weight30%25%10%10%10%15%

100%

Rating 100 = Average, 100+ = above average, 100- = belowMultiply result by $1.75M

Bill Payne Method Example

FactorManagementSize of OpportunityProduct/ServiceSales ChannelsStage of BusinessOther

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Weight30%25%10%10%10%15%

100%

Rating125115110

70125

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Total37.5028.7511.00

7.0012.5012.00

108.75

Value = $1.75M * 108.75 = $1,903,125

Risk Factor Simulation Method

Risk FactorManagementStageFunding RiskRegulatoryManufacturingSales & MktgCompetitionTechnologyLitigationReputationalExit

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Risk Factor+$500k+$250k-$250k

0+$250k-$500k+$250k+$250k

$0-$250k+$250k

$250k

ValuationBase $1.75MRisk 250kValue $2.0M

Venture Capital Method

Determine the• Investor’s required rate of return (ROI),

and• Terminal Value (TV)

Work backwards to get valuation (Post $)

TV can be either exit or next round26

VC Method Example

• TV based on estimated revenues and/or Net Income in terminal year

• Example: – Estimated revenue in Year 5 is $40M– Average multiplier for industry = 2– So your estimated value of the company at the end of year 5

, or TV = $40M * 2 = $80M

*Note: Can also estimate TV based on Net Income and apply average P/E multiples

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VC Method Example

• ROI• Say I sell an investment for $100M that I

purchased for $20M. What’s my ROI?• Answer: $100M / 20M = 5x• Same as TV/Post$ = ROI• To solve for Post$: Post$ = TV/ROI

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VC Method Example

• Say in our example that investor needs a 20X ROI• Post $ = TV/ROI• Post $ = $80M / 20• Post $ = $4,000,000

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Three Valuation Methods

Valuation Methods 409A

1. Asset Approach

2. Market Approach

3. Income Approach

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2. Market Approach

a) Recent securities transactions methodb) Comparable (guideline) public company methodc) Comparable transaction methodd) Industry-specific multiples

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2b. Market Example: Guideline Public Company Method

Data for similar public companies in same industry• Salesforce.com, Inc.• Concur Technologies, Inc.• Kenexa Corp.• LogMeIn, Inc.• Constant Contact, Inc.

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In thousands of dollars (000) LTM Revenue LTM EBITDA NTM Revenue NTM EBITDA

Venture Co. $6,812.0 ($6,337.8) $14,380.7 ($3,166.6)

Mean Multiple 5.0x 22.1x 4.0x 19.2x

Implied Enterprise Value $33,809.2 N/A $57,270.2 N/A

Average Enterprise Value $45,539.7

Plus Cash $4,441.9

Market Value of Invested Capital $49,981.6

Steps in the Valuation 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

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Valuation

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

Fair Market Value of Venture Co. as of September 30, 2012 Market Value of Method Weighted

In actual dollars Invested Capital Weighting Value

Adj. Book Value of Assets (Cost) $5,914,647 0.0% $0

Invested Capital (Cost) $22,182,037 0.0% $0

Recent Securities Transaction Backsolve (Market) $42,932,012 25.0% $10,733,003

Public Comps Valuation (Market) $49,981,604 25.0% $12,495,401

Acquisition Comps Valuation (Market) $55,094,153 25.0% $13,773,538

Discounted Cash Flow Valuation (Income) $44,606,522 25.0% $11,151,631

Weighted Market Value of Invested Capital $48,153,573

Less Debt ($1,750,000)

Weighted Equity Value $46,403,573

Step 2: Allocation

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

• Common shareholders get paid after preferred

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

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Option Value Analysis Option 1 Option 2 Option 3 Option 4 Option 5 Option 6 Option 7 Option 8 Option 9 Option 10

Definition: Before this breakpoint… Series C

liquidation

preference

Series B & A

liquidation preference

Common

participates

Allocated options

exercise

Series A converts to

common

Common

Warrants

exercise

Unallocated

options

participate in

value

Series B converts

to common

Series C reaches

3.0x

participation cap

Series C converts

into Common

stock

Break Points $0 $20,771,210 $22,182,037 $25,812,886 $27,793,293 $28,582,104 $39,428,548 $56,429,660 $301,546,405 $421,162,792 Infinity

Current Equity Value (Price) $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573

Exercise $0 $20,771,210 $22,182,037 $25,812,886 $27,793,293 $28,582,104 $39,428,548 $56,429,660 $301,546,405 $421,162,792 Infinity

Riskfree Rate 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31%

Maturity (in years) 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0

Volatility 54% 54% 54% 54% 54% 54% 54% 54% 54% 54% 54%

d1 28.942 1.333 1.264 1.103 1.025 0.995 0.654 0.275 (1.501) (1.855) 0.000

d2 27.998 0.389 0.320 0.159 0.081 0.051 (0.290) (0.669) (2.445) (2.799) 0.000

Call Option Value: $46,403,573 $28,763,403 $27,871,048 $25,735,075 $24,660,647 $24,249,313 $19,421,999 $14,152,891 $929,712 $405,738 $0

Incremental Option Value $17,640,170 $892,355 $2,135,972 $1,074,429 $411,334 $4,827,313 $5,269,108 $13,223,179 $523,975 $405,738

Option Value of Security Option 1 Option 2 Option 3 Option 4 Option 5 Option 6 Option 7 Option 8 Option 9 Option 10

Series C $17,640,170 $0 $488,775 $204,543 $67,632 $795,364 $799,205 $1,933,391 $0 $60,031

Series B $0 $697,195 $0 $0 $0 $0 $0 $414,235 $19,010 $12,542

Series A $0 $195,160 $0 $0 $40,566 $229,734 $230,844 $566,020 $26,281 $17,340

Common $0 $0 $1,647,197 $689,319 $227,924 $2,680,416 $2,693,361 $6,604,011 $306,632 $202,309

Allocated $0 $0 $0 $180,567 $59,705 $702,136 $705,527 $1,729,925 $80,322 $52,995

A Warrants $0 $0 $0 $0 $15,507 $87,821 $88,245 $216,372 $10,046 $6,628

Common Warrants $0 $0 $0 $0 $0 $331,842 $307,524 $754,035 $35,011 $23,099

Unallocated $0 $0 $0 $0 $0 $0 $444,402 $1,005,190 $46,672 $30,793

Total $17,640,170 $892,355 $2,135,972 $1,074,429 $411,334 $4,827,313 $5,269,108 $13,223,179 $523,975 $405,738

Total Option Value Option Value Total Shares

Share Value

(Marketable)

Marketability

Discount

Share Value (Non-

Marketable)

Series C $21,989,112 5,934,632 $3.705 0.0% $3.705

Series B $1,142,982 1,239,906 $0.922 0.0% $0.922

Series A $1,305,945 1,714,171 $0.762 0.0% $0.762

Common $15,051,167 20,000,000 $0.753 35.7% $0.484

Allocated $3,511,178 5,239,012 $0.670 35.7% $0.431

A Warrants $424,620 655,276 $0.648 35.7% $0.417

Common Warrants $1,451,511 2,283,567 $0.636 35.7% $0.409

Unallocated $1,527,057 3,044,179 $0.502 35.7% $0.323

Total $46,403,573 40,110,742

Summary

• STEP 1Enterprise Value $48,153,573Less Debt (1,750,000)Equity Value $46,403,573

• STEP 2Allocation to common $15,051,167Divided by # shares ÷ 20,000Price per share = $0.753

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Discount

• 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 assumptions 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 assumptions. You know your business.

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QUESTIONS AND ANSWERS

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Thank You!

Scott Goodwin, [email protected](617) 428-5407

Alicia [email protected](617) 684-5510

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Resources

To be posted to TCN website:

• Detailed outline and PowerPoint presentation• Scalar Analytics – white paper, “Section 409A – Common

Stock Valuation”