Rick's Presentation

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Rick's Presentation

  1. 1. Executive Compensation in the Post-409A Era Determining Fair Market Value for Granting Options and SARs January 16, 2008 Denver Software Club
  2. 2. Executive Compensation in the Post-409A Era <ul><li>IRS Guidance – reasonable application of a reasonable valuation method </li></ul><ul><li>Considers: </li></ul><ul><ul><li>Value of tangible and intangible assets </li></ul></ul><ul><ul><li>Present value of future cash flows </li></ul></ul><ul><ul><li>Market value of stock of similar companies </li></ul></ul><ul><ul><li>Other relevant factors such as discounts (lack of control/marketability/liquidity) </li></ul></ul>
  3. 3. Executive Compensation in the Post-409A Era <ul><li>Unreasonable to use </li></ul><ul><ul><li>a previously calculated value that fails to reflect all material information </li></ul></ul><ul><ul><li>a calculation that is more than 12 months old </li></ul></ul><ul><li>Management prepared analysis: </li></ul><ul><ul><li>Company is less than 10 years old </li></ul></ul><ul><ul><li>A liquidity event is not expected in 12 months </li></ul></ul><ul><ul><li>Put/call options to not exist on stock </li></ul></ul>
  4. 4. Executive Compensation in the Post-409A Era <ul><li>Differences with other appraisal assignments </li></ul><ul><ul><li>Assignment does not stop at enterprise value </li></ul></ul><ul><ul><li>Capital structures is a major consideration </li></ul></ul>
  5. 5. Executive Compensation in the Post-409A Era <ul><li>Value of the common stock </li></ul>Option Pricing Model Allocation of Value - Option Pricing Model Residual is Common Stock Value Price Used For Options Financing Rounds, DCF or Market Multiple Benchmarking/ Put Option Analysis 1 3 4 2 5
  6. 6. 1) Enterprise Value <ul><li>Value of the common stock </li></ul>Option Pricing Model Allocation of Value - Option Pricing Model Residual is Common Stock Value Price Used For Options Financing Rounds, DCF or Market Multiple Benchmarking/ Put Option Analysis 1 3 4 2 5
  7. 7. 1) Enterprise Value <ul><li>Fair Market Value of Enterprise </li></ul><ul><ul><li>Revenue Ruling 59-60 </li></ul></ul><ul><ul><ul><li>Nature or business since inception </li></ul></ul></ul><ul><ul><ul><li>Economic outlook for industry </li></ul></ul></ul><ul><ul><ul><li>Book value of stock </li></ul></ul></ul><ul><ul><ul><li>Earnings capacity </li></ul></ul></ul><ul><ul><ul><li>Dividends </li></ul></ul></ul><ul><ul><ul><li>Existence of goodwill and intangible value </li></ul></ul></ul><ul><ul><ul><li>Sale of the stock and size of block to be valued </li></ul></ul></ul><ul><ul><ul><li>Market prices of similar companies </li></ul></ul></ul>
  8. 8. 1) Enterprise Value <ul><li>Valuation Approaches </li></ul><ul><ul><li>Asset based approaches </li></ul></ul><ul><ul><li>Income based approaches </li></ul></ul><ul><ul><li>Market based approaches </li></ul></ul>
  9. 9. 2) Complex Capital – Allocation of Value <ul><li>Value of the common stock </li></ul>Option Pricing Model Allocation of Value - Option Pricing Model Residual is Common Stock Value Price Used For Options Financing Rounds, DCF or Market Multiple Benchmarking/ Put Option Analysis 1 3 4 2 5
  10. 10. 2) Complex Capital – Allocation of Value <ul><li>AICPA Practice Aid “Valuation of Privately Held Company Equity Securities Issued as Compensation” </li></ul><ul><ul><li>Current Value Method </li></ul></ul><ul><ul><li>Probability Weighted Expected Return Method (PWERM) </li></ul></ul><ul><ul><li>Option Pricing Methods </li></ul></ul>
  11. 11. 2) Complex Capital – Allocation of Value <ul><li>Current Value Method </li></ul><ul><ul><li>Considers what preferred and common shareholders receive if the current value is liquidated today for cash </li></ul></ul>
  12. 12. 2) Complex Capital – Allocation of Value <ul><li>Probability Weighted Expected Return Method </li></ul><ul><ul><li>Projects out various liquidity events in the future and assigns probabilities to different events </li></ul></ul>
  13. 13. 2) Complex Capital – Allocation of Value <ul><li>Option Pricing Methods </li></ul><ul><ul><li>Black-Scholes Mertons Model </li></ul></ul><ul><ul><li>Lattice Models (Binomials) </li></ul></ul><ul><ul><li>Simulation Models </li></ul></ul>
  14. 14. 2) Complex Capital – Allocation of Value <ul><li>Black-Scholes Merton Model </li></ul><ul><ul><li>Call Price = S e -q N(d 1 ) - X e -rt N(d 2 ) </li></ul></ul><ul><ul><ul><li>d 1 = [ln(S/X) + (r – q + ½  )t]/(  t ½ ) </li></ul></ul></ul><ul><ul><ul><li>d 2 = d 1 –  t ½ </li></ul></ul></ul><ul><ul><ul><ul><li>Stock price (S) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Strike Price (X) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Volatility (  ) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Interest Rate (r) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Time to Expiration (t) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Dividend Yield (q) </li></ul></ul></ul></ul>
  15. 15. 2) Complex Capital – Allocation of Value <ul><li>BSM Application to Complex Capital </li></ul><ul><ul><li>Common and preferred stock share in value above liquidation preference </li></ul></ul><ul><ul><li>Value of common stock is share of call option with liquidation preference as “strike” price </li></ul></ul><ul><ul><li>Static assumptions as to number of outstanding shares and time to liquidity event (time to expiration) </li></ul></ul><ul><ul><li>Allocates value to common and preferred stock – excludes potential dilution from outstanding options and warrants </li></ul></ul>
  16. 16. 2) Complex Capital – Allocation of Value <ul><li>Lattice Models – Binomial </li></ul><ul><ul><li>Simple 1 period Binomial </li></ul></ul>Calculate a call option with a strike price of $50 Stock price now Price in one year $50 $60 $40 Assume: r f = 5%
  17. 17. 2) Complex Capital – Allocation of Value <ul><li>Lattice Models – Binomial </li></ul><ul><ul><li>Compute payoffs: </li></ul></ul><ul><ul><ul><li>Upstate ($60): option payoff is $10 </li></ul></ul></ul><ul><ul><ul><li>Downstate ($40): option payoff is $0 </li></ul></ul></ul><ul><ul><li>Determine portfolio of 1 share of stock and (h) call options </li></ul></ul><ul><ul><ul><li>Upstate: $60 + $10 x (h) </li></ul></ul></ul><ul><ul><ul><li>Downstate: $40 + $0 x (h) </li></ul></ul></ul><ul><ul><ul><li>h = -2 (long 1 share, short 2 options) </li></ul></ul></ul>
  18. 18. 2) Complex Capital – Allocation of Value <ul><li>Lattice Models – Binomial </li></ul><ul><ul><li>Determine payoff to hedged portfolio: </li></ul></ul><ul><ul><ul><li>$60 + $10 (-2) = $40 + $0(-2) = $40 </li></ul></ul></ul><ul><ul><li>Present value of portfolio: </li></ul></ul><ul><ul><ul><li>PV = $40/1.05 = $38.10 </li></ul></ul></ul><ul><ul><li>Separate current value into parts </li></ul></ul><ul><ul><ul><li>$50 current price – $38.10 portfolio = revenue received for sale of 2 call options </li></ul></ul></ul><ul><ul><ul><li>$11.90/2 call options = $5.95 per option </li></ul></ul></ul>
  19. 19. 2) Complex Capital – Allocation of Value <ul><li>Lattice Models – Binomial </li></ul><ul><ul><li>Backward induction </li></ul></ul>$5.85 Option price Payoff $10 $0 Assume: r f = 5%
  20. 20. 2) Complex Capital – Allocation of Value 4 periods, 3 months each 52.50 50 45 50 3 months 3 months 47.50 57.50 55 60 55 50 45 40 42.50 47.50 3 months 3 months 52.50 Treat each node of the tree as a one-stage binomial problem and work your way from the back of the tree to the front to find the call option’s value
  21. 21. 2) Complex Capital – Allocation of Value 4.56 3.24 0.0 1.91 3 months 3 months 0.0 8.11 6.21 10 5 0 0 0 0.0 1.16 3 months 3 months 3.11 In the limit, as we shorten the time interval between moves and reduce the stock movement in each interval, we approach the Black Scholes option pricing model
  22. 22. 2) Complex Capital – Allocation of Value <ul><li>Simulation Models </li></ul><ul><ul><li>Uses “random” walks to determine “expected” returns for classes of stock </li></ul></ul><ul><ul><li>Numerous (10,000 +) iterations are run and statistics are analyzed </li></ul></ul>
  23. 23. 2) Complex Capital – Allocation of Value <ul><li>Simulation Models - Distribution </li></ul>
  24. 24. 2) Complex Capital – Allocation of Value <ul><li>Simulation Models - Distribution </li></ul>
  25. 25. 3) Illiquidity/Minority Discounts <ul><li>Value of the common stock </li></ul>Option Pricing Model Allocation of Value - Option Pricing Model Residual is Common Stock Value Price Used For Options Financing Rounds, DCF or Market Multiple Benchmarking/ Put Option Analysis 1 3 4 2 5
  26. 26. 3) Illiquidity/Minority Discounts <ul><li>Minority Interest Discount </li></ul><ul><ul><li>Lack of prerogatives of control </li></ul></ul><ul><li>Lack of Marketability/Illiquidity </li></ul><ul><ul><li>No ready market for shares </li></ul></ul><ul><ul><li>Potential other restrictions on sale </li></ul></ul>
  27. 27. 4) Value of Common Stock <ul><li>After allocation of value and application of discounts, remaining value is common stock </li></ul>

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