The document discusses The Capital Network, a non-profit organization that provides education and mentoring to help entrepreneurs raise capital. It offers networking opportunities through angel groups, venture capital firms, and events. The Right Network and The Right Programming sections describe connecting entrepreneurs to investors and creating workshops/mentoring to share industry trends. The summary focuses on the organization's mission to help entrepreneurs fundraise through practical education and personalized mentoring while connecting them to relevant investors and other professionals in the startup community.
1. The Capital Network is a non-profit (501c3) organization that provides practical, hands-on
education and personalized mentoring to help early stage entrepreneurs master the entire funding
process and successfully raise seed capital & beyond.
We know fundraising is hard so we provide entrepreneurs with:
Want to know more?
Follow us on @TCNUpdate www.thecapitalnetwork.org
The Right Network
We work with Angel Groups, VC Firms,
Accelerators, Community Organizations,
Service Providers and Seasoned
Entrepreneurs to help you succeed and grow
by increasing your chances of getting the right
kind of investment and connections.
The Right Programming
In collaboration with the investors who fund our
area’s startups, we create 40+ events a year -
workshops, roundtables, 1 on 1 mentoring and
bootcamps - that reflect the latest trends and
insights in the fundraising and startup
community.
3. 3
Introductions
• Scott Goodwin – Wolf & Company, PC
– Member of the Firm
– Technology Services Team Leader
– TCN board of directors
• John O’Brien – The BVC Group
– Managing Director - Owner
– Suffolk University Executive MBA Program
– Certified Valuation Analyst, CVA
– 20+ Year Corporate Finance Career – Last 10 as CFO
4. 4
Who is Wolf & Company?
• Boston based, regionally focused
• 19 owners and 220 professionals in three offices
• Niche focused
– Technology Services Team
• Provide our clients with direct access to owner-level
expertise
• Ability to grow with you
5. 5
Who is the BVC Group?
• 120+ 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
• Have worked on a number of recent Biotech IPOs
in the last 48 months
6. 6
Agenda
• “An entrepreneur and a CPA walk into a bar….”
– An informal Q&A between a (hypothetical)
entrepreneur and a CPA
• The who, what, why and how of valuations
• Q&A
7. 7
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “I think I’m ready to start issuing
people equity instruments. What do I need to
know before I do that?”
CPA –
• First of all, you need to determine what types of instruments you want
to issue:
– Options
– Restricted stock
– Hybrid – restricted stock units (RSUs)
• There are advantages/disadvantages of each but for purposes of our
discussion we’re going to focus on options
– Most common type of instrument we see at early-stage companies
8. 8
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “I think I’m ready to start issuing
people equity instruments. What do I need to
know before I do that?”
CPA –
• A few considerations
– Do you actually want the recipient to be a shareholder?
– Do you want the recipient to receive some of the value of the
company already created or just benefit from increases in value in
the future?
9. 9
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “What is the difference between
incentive stock options (ISOs) and nonqualified
stock options (nonquals)?”
CPA –
• The easy answer…..the tax treatment!
• Before we get too far, let’s agree on some option terminology:
– Exercise price
• Price at which recipient can purchase stock over a set period of time
• Fixed on the grant date
– Fair value of underlying stock – changes over time
– Intrinsic value – difference between the two
10. 10
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “What’s the difference between
incentive stock options (ISOs) and nonqualified
stock options (nonquals)?”
CPA –
• An incentive stock option gets the following 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
11. 11
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “What’s the difference between
incentive stock options (ISOs) and nonqualified
stock options (nonquals)?”
CPA –
• A nonqual gets the following tax treatment:
– No tax at issuance
– No tax upon vesting
– Taxable income equal to the intrinsuc on the exercise date
– Ordinary income
• Possible additional tax when stock sold
12. 12
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “Clearly ISOs are the way to go. How
do I make sure the options I issue are ISOs?”
CPA –
• In order to qualify as an ISO, the option has to meet 8
criteria
– Three of the more important ones
• Issued under a formal written plan
• Exercise price >= FMV of stock
• Can’t be issued to non-employee
• Everything that doesn’t qualify as an ISO is a nonqual
automatically
13. 13
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “I think I’m getting the hang of these
options. What is this 409A thing I’ve heard about?”
CPA –
• It’s part of the Internal Revenue Code
– Just one more thing we can blame the IRS for!
– No impact on accounting rules
• Very comprehensive with far reaching impacts/scope
• Regulations governing a wide array of non-qualified
deferred comp arrangements, including options
14. 14
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “My company is generating losses and
409A relates to income taxes. So why should I care?
What’s the worst that could happen?”
CPA –
• Your option issuance, intended as an EE benefit, could cause
serious tax problems for the recipient
• How serious? From the EE’s perspective -
– Ordinary income in the periods in which options vest rather than
when exercised
– Regular income tax rates
– 20% penalty
– Possible interest and penalties for late payment
15. 15
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “My company is generating losses
and 409A relates to income taxes. So why should I
care? What’s the worst that could happen?”
CPA –
• And from the ER’s perspective -
– Very unhappy employees!
– Payroll tax withholding obligation
– ER portion of employment taxes
– Possible responsibility for EE’s portion of withholdings
16. 16
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “My company is generating losses and
409A relates to income taxes. So why should I care?
What’s the worst that could happen?”
CPA –
• Practically speaking, 409A has resulted the following:
– Can no longer issue options (safely) using a rule-of-thumb or simple
board approval
– In-the-money options are impractical
– Incentivized companies to get outside valuations of their stock
– Incentivized companies to be more disciplined in their granting
17. 17
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “Ok, I’m now sufficiently scared.
What do I need to know about 409A to stay out of
trouble?”
CPA –
• The general compliance requirements for 409A include:
– Exercise price must be >= FMV of underlying common stock
– FMV must be determined by the “reasonable application of a
reasonable valuation methodology”
– Valuation must be within 12 months of when it is being used
18. 18
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “Ok, I’m now sufficiently scared.
What do I need to know about 409A to stay out of
trouble?”
CPA –
• There are safe harbor valuation methodologies spelled out
in 409A
– 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 IRS if the company's application of the
method is found to be "grossly unreasonable"
19. 19
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “I like the sounds of a safe harbor.
How do I take advantage of those?”
CPA –
• Independent appraisal
• 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)
• Binding formula
20. 20
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “What is the bottom line of all this
option and 409A stuff?”
CPA –
• Here’s the bottom line – if you’re issuing most forms of
stock-based compensation
– You will need to know the value of your company
– You will most likely need to comply with the requirements of 409A
– You will eventually need to get a valuation
21. 21
“An entrepreneur and a CPA walk into a
bar….”
Entrepreneur - “So when do I absolutely, positively
need to get an independent valuation?”
CPA –
• Technically, never
• Practically speaking
– You need to assess your own risk/reward situation
– Your investors and prospective investors will be asking you about it
– When you exit, it will come up in due diligence
– Sooner is better than later
23. Standard of Value
• Fair Market Value
– Assumes hypothetical willing buyer and willing
seller
– This is the standard for 409A (per IRS)
• Fair Value
– Assumes the value is an exit value in the optimal
market
– This is standard of value for financial reporting
• For 409A purposes FMV should equal FV
23
24. Standard of Value (cont’d)
• In a 409A valuation there are two masters
– The IRS
– The financial auditors
• Need a valuation that satisfies both Masters
• AICPA Practice Aid
– The guide book to 409A valuations
– Best practices – influenced by the SEC
24
25. Valuation
for Start-Ups
• Discounted Cash Flow
• Recent Transactions Method
– Backsolve Method based on recent equity
financing
– Utilizes an Option Pricing Model (“OPM”)
• Hybrid Method
– Combination of the OPM and other
methods/scenario analyses
25
26. Steps in the Valuation Process
• Take weighted average of applicable methods
(asset, market or income) to come up with equity
value
• Allocate the equity value among classes of stock
26
27. Common Stock Valuation
• First Step – Determine the Business
Enterprise Value “BEV”
• BEV – Is the value of the entire business
• Equity Value is:
– BEV minus debt plus cash = Equity Value
– Sometimes used interchangeably but they are not the
same thing
• Equity Value is then Allocated to the various share
classes
• That is a common stock valuation
27
28. Three Valuation Methods for BEV
• Formal Valuation Methods 409A
• Asset Approach
• Market Approach
• Income Approach
28
29. Asset Approach
• Use of this approach very limited
• Adjusts the Assets of the Company to their
FMV or FV
– Replacement cost method
– Relief from Royalty Method
• Sometimes used when initial funding is a
convertible note and little accomplished in
way of intellectual property development
29
30. Market Approach
• Recent Transactions Method (“RTM”)
• Arms’ length transaction in the Company’s own equity
securities
• Guideline Public Company Method
• Not likely to be used for early stage Company
• Need Revenue for this approach
• Guideline Transactions Method
• Not likely to be used for early stage Company
• Need Revenue for this approach
30
31. Income Approach
• Discounted Cash Flow Method
• Utilizes projection provided by Management
• Requires a terminal value calculation
• Constant Growth
• Two-Stage Growth
• H-Model
• Revenue Exit Multiple
• EBITDA Exit Multiple (Earnings before Interest, Taxes,
Depreciation and Amortization)
31
32. Income Approach (cont’d)
• Early Stage Companies most commonly need the exit
multiple method for the terminal value calculation
32
Terminal Value - Revenue Multiple Method
2019 Revenue $ 12,025,700
Revenue Exit Multiple 2.00x
Terminal Value $ 24,051,400
Present Value Period 5.00
Present Value Factor 18.9% 0.421
Present Value of Terminal Year $ 10,121,179
33. Income Approach (cont’d)
• The future projected cash flows and the terminal value are
present valued or discounted back today by using what is called
• Weighted Average Cost of Capital (WACC) or Discount Rate
• Two terms used interchangeably
• Number of Methods used to calculate the WACC or discount
rate
• Capital Asset Pricing Model (CAPM)
• Build-up Method
• Duff & Phelps Build-up Method
• Venture Capital Rates of Return Studies
33
34. Income Approach (cont’d)
• Below is a table associated with the VC Rates of Return
Studies and the ranges of discount rates at the various
stages of development
34
Scherlis and
Stage of Development (1) Plummer (2) Sahlman (3)
Start-up (4) 50% - 70% 50% - 70%
First stage or "early development" (5) 40% - 60% 40% - 60%
Second stage or "expansion" (6) 35% - 50% 30% - 50%
Bridge/IPO (7) 25% - 35% 20% - 35%
35. Allocating the Equity
• Methods used to allocate the equity value:
– Option Pricing Model (Black-Scholes)
– Probability Weighted Expected Returns Method (PWERM)
• Scenario analysis when close to a liquidity event
– Direct Waterfall or Current Value Method
• Very simple capital structure or weeks from a liquidity event
• Profits Interest in an LLC
– Hybrid Method
• Mix of the OPM and the other allocation methodologies
• Most common method prescribed with early stage
companies is the OPM
35
36. Option Pricing Model
• Step 1 – Determine the Breakpoints
36
Breakeven Breakeven Breakeven
Point #1 Point #2 Point #3
Series A Common Series A
Liquidation Options @ Converts @
Description Preference $0.15 $1.00
Conversion/Exercise Breakeven Point Per Share $ 0.15 $ 1.00
Liquidation Preference of Series A Preferred Stock $ 1,370 $ 1,370 $ -
Less: Net Effect of Proceeds from Options $ (17) $ (17)
Equity Value at Conversion/Exercise Breakeven Point (Strike Price) $ 1,370 $ 2,418 $ 8,449
Shares Included in Breakeven Point Calculation
Series A Preferred 1,370
Common Shares 6,985 6,985
Common Options @ $0.15 110 110
Total Shares Included in Breakeven Point 7,095 8,465
Multiply: Conversion/Exercise Breakeven Point Per Share $ 0.15 $ 1.00
Value Allocated to Common Units, Shares/Warrants, and Converted/Participating Preferred $ 1,064 $ 8,465
38. Option Pricing Model
• Step 3 – Allocate the value to the share classes
38
Series A
Tranche Preferred Common Common
Description Value Stock Stock Options Totals
Tranche 1 $ 1,359 $ 1,359 $ 1,359
Percent Allocated 100.00% 100%
Tranche 2 $ 927 $ - $ 927 $ 927
Percent Allocated 100.00% 100%
Tranche 3 $ 1,628 $ 1,603 $ 25 $ 1,628
Percent Allocated 98.45% 1.55% 100%
Tranche 3 $ 85 $ 14 $ 70 $ 1 $ 85
Percent Allocated 16.18% 82.52% 1.30% 100%
Total Value By Round $ 4,000 $ 1,373 $ 2,601 $ 26 $ 4,000
Total Units By
Class 1,370 6,985 110 8,355
Value Per Share $ 1.00 $ 0.37 $ 0.24
39. OPM – Key Inputs
• Time to liquidity
– M&A Event
– Next Round of Financing
• Volatility
– Based on public companies and their volatility
• Risk Free Rate – US Treasury
39
40. Discounts
• Discount for Lack of Marketability (DLOM)
– Reflects the illiquid nature of the security – you can’t call your
broker and sell
– Range from 5% to 35%
• IRS is pushing back hard on discounts greater than 35% in all valuations
– Number of models can quantify an implied DLOM
• Put Option Model
• Finnerty Model
• About 5 others
• IPO Studies
– DLOM is applied after the Allocation Methodology not before
– Remember the Recent Transactions Method is an investment in an
illiquid security – discount should not be the same as calculated
implied DLOM
40
41. Discounts (cont’d)
• Discount for Lack of Control (DLOC)
– Reflects the lack of control a minority investor has in regards to
the operation of the Company
– Generally not to be used in 409A valuations
• SEC has basically limited the use of this discount to very limited circumstances
which generally don’t apply to 99% of the companies.
• IRS is pushing back hard on discounts greater than 35% in all valuations
– Can be used when working with the Guideline Transactions
Method within the enterprise valuation. GTM is a control level of
value and it should be discounted to get to a minority level of
value.
– If a control discount is applied after the allocation methodology it
is wrong in 99% of the cases
41
42. Discounts (cont’d)
• Application of Discounts
42
Description Amount
Implied Equity Value $4,000
Implied Value of the Series A Share $ 1.00
Common Stock Value Minority, Marketable Basis $0.37
Discount for Lack of Marketability/Liquidity 20%
Common Stock Value Minority, Non-Marketable Basis $0.30
Common as a Percentage of Series A Preferred Share 29.7%
43. RTM – Ranges of Value Guidelines
• Convertible Preferred – No dividends, no participation and
1x liquidation preference
– 30% to 40% of the Preferred in a straight OPM
• Convertible Preferred – has dividends, no participation and
1x liquidation preference
– 25% to 35% of the Preferred in a straight OPM
• Participating Preferred – no dividends, 1x liquidation
preference
– 15% to 25% of the Preferred in a straight OPM
• Based on today’s standards the 10% of the preferred value
rule is no longer applicable. Does happen just not often
43
44. Hiring a Valuator – Need to Knows
• Does the valuator have a valuation credential?
– CVA, CFA, ABV, ASA
• Are you talking to the person who will actually perform the
valuation or a sales/business development professional
• Does this person provide other services or do they
specialize in business valuation
• Does the valuator follow the standards laid out in the AICPA
Practice Aid.
• Resist the urge to hire based solely on price
– Do you hire your doctor this way?
– Price can be a consideration but it shouldn’t be the only one.
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