This document discusses equity compensation and IRC Section 409A compliance. It provides an overview of common stock compensation plans and the tax treatment. Section 409A aims to regulate nonqualified deferred compensation and can impose penalties if not followed. The document then outlines several methods for valuing private companies for 409A compliance, including the Berkus method, Bill Payne method, and venture capital method. It walks through a detailed example of performing a valuation using these approaches and determining a fair market value per share of common stock.

1. Know Your Valuation For Equity
Compensation (and Avoid the
Perils of 409A)
Exclusively for
MEMBER OF PKF NORTH AMERICA, AN ASSOCIATION OF LEGALLY INDEPENDENT FIRMS © 2010 Wolf & Company, P.C.

2. 2
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, Boston office
– Instructor of Entrepreneurial Finance, Tufts University
– CPA and Certified Valuation Analyst, CVA
– Past CFO

3. 3
Who is Wolf & Company?
• Boston based, regionally focused
• 18 owners and 190 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
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

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
– Options
– Restricted stock
• Tax treatment
• Advantages and disadvantages

7. 7
Overview of IRC
Section 409A
• What is it?
• How does it impact stock compensation?
• What is the worst that could happen?
• What do you as an entrepreneur need to know to
stay out of trouble?
• What are best practices at various stages of
development?

8. Standard of Value
• Fair Market Value
– Assumes hypothetical buyer
– This is standard for 409A (per IRS)
• Investment Value
– Assumes strategic buyer
409A ≠ VC investment
8

9. Investment Valuation for Start-Ups
• Discounted Cash Flow???
• Berkus
• Bill Payne Method
• Risk Factor Simulation
• Venture Capital Method
9

10. David Berkus Method
10
$500k for each
• Good idea
• Prototype
• Quality Team
• Quality Board
• Initial Sale
Value $0 to $2.5 Million

11. Bill Payne Method
Factor
Management
Size of Opportunity/Market
Product/Service
Sales Channels
Stage of Business
Other
11
Weight
30%
25%
10%
10%
10%
15%
100%
Rating 100 = Average, 100+ = above average, 100- = below
Multiply result by $1.75M

12. Bill Payne Method Example
Factor
Management
Size of Opportunity
Product/Service
Sales Channels
Stage of Business
Other
12
Weight
30%
25%
10%
10%
10%
15%
100%
Rating
125
115
110
70
125
80
Total
37.50
28.75
11.00
7.00
12.50
12.00
108.75
Value = $1.75M * 108.75 = $1,903,125

13. Risk Factor Simulation Method
Risk Factor
Management
Stage
Funding Risk
Regulatory
Manufacturing
Sales & Mktg
Competition
Technology
Litigation
Reputational
Exit
13
Risk Factor
+$500k
+$250k
-$250k
0
+$250k
-$500k
+$250k
+$250k
$0
-$250k
+$250k
$250k
Valuation
Base $1.75M
Risk 250k
Value $2.0M

14. 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 round
14

15. 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
15

16. 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
16

17. VC Method Example
• Say in our example that investor needs a 20X ROI
• Post $ = TV/ROI
• Post $ = $80M / 20
• Post $ = $4,000,000
17

18. Three Valuation Methods
Formal Valuation Methods 409A
1. Asset Approach
2. Market Approach
3. Income Approach
18

19. 2. Market Approach
a) Recent securities transactions method
b) Comparable (guideline) public company method
c) Comparable transaction method
d) Industry-specific multiples
19

20. 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.
20
In thousands of dol lars (000) LTM Revenue LTM EBITDA NTM Revenue NTM EBITDA
Venture Co. $6,812.0 ($6,337.8) $14,380.7 ($3,166.6)
Mean Mul tiple 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

21. 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
21

22. Valuation
7
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

23. 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
23

24. 24
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

25. Summary
• STEP 1
Enterprise Value $48,153,573
Less Debt (1,750,000)
Equity Value $46,403,573
• STEP 2
Allocation to common $15,051,167
Divided by # shares ÷ 20,000
Price per share = $0.753
25

26. 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
26

27. 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.
27

28. 28
QUESTIONS AND ANSWERS

29. 29
Thank You!
Scott Goodwin, CPA
sgoodwin@wolfandco.com
(617) 428-5407
Alicia Amaral
alicia.amaral@scalaranalytics.com
(617) 684-5510

30. 30
Resources
To be posted to TCN website:
• Detailed outline and PowerPoint presentation
• Scalar Analytics – white paper, “Section 409A – Common
Stock Valuation”