The document discusses key considerations for equity compensation and avoiding issues with Internal Revenue Code Section 409A. It provides an overview of common forms of equity compensation like stock options, restricted stock, and founders' shares. It also summarizes the requirements of Section 409A, including using a reasonable valuation methodology to determine the fair market value of stock for option grants. Finally, it discusses best practices for startup companies in complying with Section 409A at different stages, including potentially using the independent appraisal or illiquid startup safe harbors for valuations.

1. 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

2. 2
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

3. 3
Who is Wolf & Company?
• Boston based, regionally focused
• 20 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

4. 4
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

5. 5
Agenda
• Overview of stock compensation plans
• Overview of IRC Section 409A
• The who, what, why and how of valuations
• Q&A

6. 6
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

7. 7
Stock Compensation
Overview
• 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

8. 8
Stock Compensation
Overview
• 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

9. 9
Stock Compensation
Overview
• 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?

10. 10
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

11. 11
Overview of IRC
Section 409A
• 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

12. 12
Overview of IRC
Section 409A
• 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

13. 13
Overview of IRC
Section 409A
• 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”

14. 14
Overview of IRC
Section 409A
• 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."

15. 15
Overview of IRC
Section 409A
• 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

16. 16
Overview of IRC
Section 409A
• 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

17. 17
Overview of IRC
Section 409A
• 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.

18. 18
Overview of IRC
Section 409A
• 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

19. 19
Overview of IRC
Section 409A
• 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

20. The Million Dollar Question:
What is my company worth??
20

21. 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
21

22. 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
22

23. 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
23

24. 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
24

25. 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
25

26. Three Valuation Methods for BEV
• Formal Valuation Methods 409A
• Asset Approach
• Market Approach
• Income Approach
26

27. 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
27

28. 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
28

29. 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)
29

30. Income Approach (cont’d)
• Early Stage Companies most commonly need the exit
multiple method for the terminal value calculation
30
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

31. 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
31

32. 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
32
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%

33. 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
33

34. Option Pricing Model
• Step 1 – Determine the Breakpoints
34
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

35. Option Pricing Model
• Step 2 – Determine the Tranche Values
35
Call Call Call
Description Option #1 Option #2 Option #3
Equity Value (Underlying Asset) [a] $ 4,000 $ 4,000 $ 4,000
Conversion/Exercise Breakeven Point (Strike Price) $ 1,370 $ 2,418 $ 8,449
Time Until Liquidity/Next Round of Financing (In
Years) 1.00 1.00 1.00
Risk Free Rate 0.33% 0.33% 0.33%
Volatility (Standard Deviation) [a] 50% 50% 50%
Variance 0.250 0.250 0.250
Dividend Yield 0% 0% 0%
Call Option Value $2,641 $1,714 $85
Tranche
Description Value
Equity Value - Call Option 1 Tranche 1 $ 4,000 $2,641 $ 1,359
Call Option 1 - Call Option 2 Tranche 2 $ 2,641 $ 1,714 $ 927
Call Option 2 - Call Option 3 Tranche 3 $ 1,714 $ 85 $ 1,628
Allocation of the Remainder Tranche 4 $ 85 $ - $ 85
Totals $ 4,000

36. Option Pricing Model
• Step 3 – Allocate the value to the share classes
36
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

37. 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
37

38. 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
38

39. 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
39

40. Discounts (cont’d)
• Application of Discounts
40
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%

41. 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
41

42. 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.
42

43. 43
QUESTIONS AND ANSWERS

44. 44
Thank You!
Scott Goodwin, CPA
sgoodwin@wolfandco.com
(617) 428-5407
John O’Brien
jobrien@thebvcgroup.com
(603) 249-5469

45. 45
Resources
To be posted to TCN website:
• Detailed outline and PowerPoint presentation