Venture capital-backed IPOs have significantly outperformed the broader IPO market and non-venture backed companies over the past several years. On average, venture-backed companies saw stock price increases of 18.8% on the first day of trading and 10.5% after six months. Several factors contribute to their strong performance, including venture capitalists selecting companies based on long-term scalability rather than short-term profits. Venture firms also help professionalize the companies they invest in to prepare them for successful public listings. Recent regulatory changes and competitive stock exchanges could further increase IPO activity for venture-backed firms going forward.

1. VENTURE CAPITAL REVIEW
Issue 28 • 2012
produced by the National Venture Capital Association and Ernst & Young llp

2. National Venture Capital Association (NVCA)
As the voice of the U.S. venture capital community, the National Venture Capital Association
(NVCA) empowers its members and the entrepreneurs they fund by advocating for policies
that encourage innovation and reward long-term investment. As the venture community’s
preeminent trade association, NVCA serves as the definitive resource for venture capital data
and unites its 400 plus members through a full range of professional services. Learn more at
www.nvca.org.
National Venture Capital Association
1655 Fort Myer Drive
Suite 850
Arlington, VA 22209
Phone: 703.524.2549
Fax: 703.524.3940
Web site: www.nvca.org

3. 3
Venture-Capital-Backed IPOs: Outperforming the Market and Creating
Market Leaders
By Jacqueline A. Kelley and Bryan Pearce, Partners of Ernst & Young LLP
11
Midstream Shareholder Liquidity Alternatives: Structuring Shareholder
Take-Outs in Growth Equity Financings
By Dan Meehan and Alfred L. Browne of Cooley LLP
25
Contingent Consideration: Does it Have Value?
By Steven Nebb, CFA and David L. Larsen, CPA, Managing Directors of Duff & Phelps LLC
31
Acqui-Hires for Growth: Planning for Success
By Marita Makinen, David Haber and Anthony Raymundo of Lowenstein Sandler PC
43
Anticipating Inflection Points: The Necessity of Managing Uncertainty in
the Law in the Formation and Operation of Private Investment Funds
By Timothy W. Mungovan and Joel Cavanaugh of Proskauer Rose LLP
51
The Emergence of the SecondMarket
By Adam Oliveri, Managing Director and Head of the Private Company Market at SecondMarket
55
Culture is a Business Issue
By Liz Brashears, Director, Human Capital Consulting at TriNet
Please send comments about articles in this issue or suggestions regarding
topics you would like to see covered in future issues to Jeanne Metzger,
NVCA’s Chief Marketing Officer, at jmetzger@nvca.org.

4. 2

5. Venture-Capital-Backed IPOs:
Outperforming the Market and
Creating Market Leaders
By Jacqueline A. Kelley and Bryan Pearce, Partners of Ernst & Young LLP
Confirming the invigorating effect venture capitalists
have on entrepreneurship in the US, IPOs of venturecapital-backed companies on US exchanges
outperform the IPO market in general.
These findings are revealed in a recent Ernst & Young
analysis of data provided by Dealogic. [see table].
In this article, we will explore how, in doing much
more than providing capital to entrepreneurs, venture
capitalists have a significant impact on the market
performance of their investees.
The market performance of venture-backed companies
that go public is notable. Even in the volatile equities
market of the last five years, the average one-day
post-IPO return of venture-backed companies between
early 2007 and June 2012 was 18.8%, more than three
times the return of companies that did not accept
venture capital investment. At six months, these same
companies still outperformed their counterparts. While
the one-year post-IPO performance of all companies
was affected by the 2007-08 financial crisis, and
more recently by the Eurozone crisis, it is important
to note that there have been enormous successes
even in a difficult market. In recent years, the oneyear post-IPO return of a number of venture-capitalbacked companies has exceeded 25%. The standouts
include information technology security firm Fortinet,
whose one-year post-IPO return topped 150%; the
professional social networking site LinkedIn, whose
one-year return topped 120%; and the restaurant
reservation site OpenTable, whose one-year return
topped 105%.
3

6. Average IPO Proceeds ($mm)
2007
2009
2010
2011
2012 YTD
2007 to
June 2012
134.6
VC backed IPOs
2008
128.0
145.1
110.7
201.7
101.0
138.6
PI backed IPOs*
195.7
232.9
287.7
160.8
382.8
168.4
227.6
Non PI-backed IPOs
295.3
175.6
322.8
146.0
190.4
215.4
232.5
All IPOs
222.0
184.2
278.7
143.2
272.4
157.9
208.2
All IPOs without exclusion
222.0
581.4
371.5
220.5
272.4
304.7
271.9
Total IPO volume
Total IPO Proceeds ($mm)
2007
2008
2009
2010
2011
2012
YTD
2007
to
June
2012
2007
2008
2009
2010
2011
2012
YTD
2007
to
June
2012
VC backed IPOs
57
7
12
64
51
32
223
7,670
896
1,742
7,087
10,288
3,231
30,913
PI backed IPOs*
123
13
36
109
78
53
412
24,069
3,027
10,357
17,527
29,855
8,927
93,763
Non PI-backed
IPOs
112
28
29
59
61
22
311
33,074
4,916
9,362
8,614
11,612
4,739
72,317
All IPOs
292
48
77
232
190
107
946
64,813
8,840
21,461
33,228
51,754
16,897
196,993
All IPOs
without exclusion
292
49
78
233
190
108
950
64,813
28,490
28,978
51,368
51,754
32,904
258.308
Note: Exclude IPO of Visa Inc; General Motors Co; Banco Santander Brasil SA; Facebook to eliminate skewness of averages
* Private-investment-backed IPO refers to backing by PE firm or by VC firm or by both
Source: Dealogic, Thomson Financial, Ernst & Young
US exchanges IPOs
Door number 1, 2 or 3? Which is the
best exit?
(JOBS) Act has eased the regulations associated with
an IPO for emerging-growth companies — those with
under $1 billion in revenue (among other tests) — and
may be bringing new companies into the IPO pipeline.
Under the JOBS Act, emerging-growth companies are
now able to file confidential IPO registration statements
with the Securities and Exchange Commission
(SEC). In just the brief period between April 5 of this
year, when the JOBS Act took effect, and late May,
about 30 companies took advantage of this and filed
confidentially, according to the SEC’s Paula Dubberly.2
The data suggests that given the excellent
performance of their portfolio company IPOs in
recent years, venture capitalists should give closer
consideration to an IPO as an exit strategy for more of
their portfolio companies. Currently, venture-capitalbacked IPOs are just 8% of the total exit pool,1 in part
because the ongoing Eurozone crisis and US election
year uncertainty continue to dampen enthusiasm for
IPOs among all players. However, in recent years, the
percentage of venture-backed companies exiting via an
IPO has been as high as 14%.
Finally, venture-backed companies continue to perform
superbly after their IPOs. The National Venture Capital
Association/Thomson Reuters Exit Poll Report for
the second quarter of 2012 found that 9 out of the 11
venture-backed IPOs brought to market in the quarter
were trading above their offering price.3
There are other reasons for optimism about the
venture-backed IPO market, as indicated by the fact
that two American exchanges, the New York Stock
Exchange as well as the NASDAQ, are currently
actively competing for venture-backed offerings. In
addition, the new Jumpstart Our Business Start-Ups
2 Emily Chasen, “Confidential IPO Filings Outpacing Public Ones,” Wall Street
Journal’s CFO Journal, May 30, 2012, http://blogs.wsj.com/cfo/2012/05/30/
confidential-ipo-filings-outpacing-public-ones, accessed July 19, 2012.
3 Exit Poll Report, National Venture Capital Association/Thomson Reuters,
July 2, 2012.
1 VentureSource, Q1 2012 data.
4

7. Average post IPO performance - 1 day (%)
Average post IPO performance - 1 month (%)
2007
to
June
2012
2007
2008
2009
2010
2011
2012
YTD
2007
to
June
2012
2007
2008
2009
2010
2011
2012
YTD
VC backed IPOs
18.3
6.7
16.7
16.8
20.5
24.6
18.8
15.4
12.4
12.5
19.1
15.7
30.5
18.3
PI backed IPOs*
17.3
7.3
11.0
12.6
16.5
20.6
15.5
16.5
11.7
11.0
14.3
12.9
22.5
15.3
8.9
11.1
5.9
4.4
0.9
2.7
6.0
6.4
(2.9)
16.6
2.5
(2.7)
4.2
3.9
Non PI-backed IPOs
Average post IPO performance - 6 months (%)
Average post IPO performance - 1 year (%)
2007
to
June
2012
2007
2008
2009
2010
2011
2012
YTD
2007
to
June
2012
2007
2008
2009
2010
2011
2012
YTD
VC backed IPOs
11.5
1.8
10.8
28.0
(4.8)
-
10.5
(17.2)
(0.4)
27.4
13.3
(11.4)
-
(1.1)
PI backed IPOs*
5.2
(17.4)
13.7
27.8
(0.3)
-
9.5
(19.0)
(17.9)
27.4
16.0
(2.8)
-
0.0
Non PI-backed IPOs
2.3
(24.4)
17.2
2.3
(4.9)
-
(0.3)
(20.8)
(31.9)
5.3
(12.4)
(12.9)
-
(16.2)
Note: Exclude IPO of Visa Inc; General Motors Co; Banco Santander Brasil SA; Facebook to eliminate skewness of averages
* Private-investment-backed IPO refers to backing by PE firm or by VC firm or by both
Source: Dealogic, Thomson Financial, Ernst & Young
US exchanges IPOs
Top Sectors
(# of Deals)
2011
Top Sectors
(# of Deals)
2012
YTD
Top Sectors
(capital raised $mm)
2011
Top Sectors
(capital raised $mm)
2012
YTD
High Technology
34
High Technology
20
High Technology
8,902
Oil & gas
3,006
Financial
22
Financial
10
Health care
5,879
High technology
2,320
Oil & gas
21
Oil & gas
8
Oil & gas
5,720
Financial
2,077
Health care
16
Health care
6
Financial
4,200
Retail
Real estate
9
Retail
5
Power & utilities
3,372
The venture capital effect
initially unprofitable but highly innovative companies
Academic studies suggest why venture-backed IPOs
perform better than the market.
that could not possibly fund their own growth the
First, venture capitalists take a long-term view when
selecting companies for funding. A forthcoming
Journal of Finance article considered 25 years of
U.S. Census Bureau data that tracks firms from their
birth and found that venture capitalists choose their
portfolio companies based on their scalability, rather
than short-term profitability.4 Clearly, venture capitalists
perform an important function in an economy that
depends on groundbreaking technologies. They give
876
venture capitalists’ preference for scalability meets
chance to gestate and mature. At the same time,
the demands of today’s capital markets, which expect
companies to have long-term growth potential.
Second, venture capitalists set the stage for further
growth by actively professionalizing the young
companies in which they invest. Another recent study,
which looked at 3,200 entrepreneurial firms that went
public between 1993 and 2004, found that venturebacked firms are associated with higher management
4 Manju Puri and Rebecca E. Zarutskie, “On the Lifecycle Dynamics of VentureCapital- and Non-Venture-Capital-Financed Firms,” The Journal of Finance,
http://www.afajof.org/journal/forth_abstract.asp?ref=708, accessed
July 19, 2012.
quality, as measured by factors that include
management team size, education, prior experience
5

8. Operate like a public company long
before your firm becomes one
and core functional expertise.5 Management quality
and venture-backing, in turn, certify the firm’s value to
the IPO markets and have a number of positive effects
on venture-backed IPOs, including increasing firm
valuations both in the IPO market and in the immediate
secondary market.
At successful companies, an IPO is not a single
event, but a transformational process. Long before
the company engages in the four phases of the
IPO ramp-up — due diligence, drafting, SEC review
and marketing — time should be spent on planning
and processes. Businesses intending to go public
in the next year or two should develop a formal,
comprehensive written plan and timeline. They
should develop an integrated transaction strategy
that formalizes policies, procedures, reporting and
communications. They should work on the legal,
financial, technological and risk management
infrastructure required of a public company. And they
should address key financial and reporting issues,
including accounting for stock option issuance and
revenue recognition.
Finally, since venture capital tends to specialize and
concentrate in a few high-growth sectors of the
economy — including information technology, life
sciences and cleantech — venture capitalists not only
understand their portfolio companies’ businesses
and markets particularly well, but also can offer the
management of these companies valuable guidance at
every juncture.
This “venture capital effect” can be enormous. Over the
period of a typical venture capital investment, venturecapital-financed companies are half as likely to fail as
non-venture-capital-financed companies, 32 times
more likely to be acquired and 805 times more likely to
go public.6
Keep an open mind
Every year, venture capitalists achieve an exit for
significantly more of their portfolio companies through
an M&A transaction rather than an IPO. Though such
private M&A exits may lack some of the prestige of a
stock market listing, they can be an effective and less
costly vehicle for raising funds and realizing an optimal
company valuation.
Intensifying the venture capital effect:
10 steps to IPO readiness
At Ernst & Young, our experience with these young,
high-growth venture-backed companies, supported
by substantial research, suggests that companies
beginning the process of preparation for an anticipated
IPO 12 to 24 months in advance will typically
outperform the market when they eventually complete
their offerings.
Private buyers often appear soon after a company
strengthens its infrastructure and signals its intentions
to go public. A multitrack approach during the IPO
preparation process can therefore help a company
improve its chances of raising capital and achieving the
highest possible valuation. Multitrack options include:
Even when an IPO is not on the immediate agenda,
early preparation will allow a company to take
advantage of an IPO window should one open
unexpectedly — and enhance the company’s value
should a merger or acquisition be the ultimate
outcome.
• sale to a private equity firm
A
• sale to a strategic buyer
A
• artnerships, joint ventures and strategic alliances
P
Are your companies ready for the IPO Value Journey®?
Here are the steps we recommend at Ernst Young.
• lternative liquidity options, such as Rule 144A
A
placements or private exchanges and
cross-border listings
We recommend taking into account all attractive
alternatives. It should be noted that the ability to
conduct confidential filings under the JOBS Act may
impact the multitrack process, as the intentions of
companies choosing the confidential filing alternative
may not be as well understood in the public markets
until later in the public offering process.
5 Thomas J. Chemmanur, Hassan Tehranian and Karen Simonyan, “Management
Quality, Venture Capital Backing, and Initial Public Offerings,” Social Science
Research Network, http://papers.ssrn.com/sol3/papers.cfm?abstract_
id=2021578, accessed June 17, 2012.
6 Manju Puri and Rebecca E. Zarutskie, “On the Lifecycle Dynamics of VentureCapital- and Non-Venture-Capital-Financed Firms,” The Journal of Finance,
http://www.afajof.org/journal/forth_abstract.asp?ref=708, accessed
July 19, 2012.
6

9. Develop a brilliant sense of timing
Even when the company is ready, it might be
necessary to delay the IPO if the markets are
unfavorable or there is a glitch in the offering process.
Timing is crucial to the success of IPOs. Instead of
asking whether the stock market is ready for it, a
company first needs to ask whether it is ready for
the stock market. Input from a variety of external
advisors, including investment bankers, attorneys and
auditors, can help board members and management
develop a realistic timeline for an IPO. It is important
to communicate this expected timeline to key
stakeholders throughout the process.
On the other hand, when an IPO is timed perfectly,
the company can price its shares to yield an optimal
valuation and the highest possible returns for its
investors. Every IPO-bound company should be
prepared to quickly enter into the registration process
when a window of opportunity appears.
7

10. Company leadership must strike
the right balance between managerial focus
on the IPO transaction and the day-to-day
operation of the company.
Convene a superb team
Information systems need to be aligned both with
the company’s business objectives and critical
reporting requirements. Management should have the
information tools that allow it to make good decisions
and answer analysts’ questions quickly.
Clearly, the market looks for companies with highquality management teams, and strong IPO performers
typically begin the process of strengthening their
management team a full one to two years in advance
of an offering. It is crucial that venture capitalists work
with the board as a whole and the CEO to determine
whether key players have the skill sets necessary to run
a public company.
Establish excellent corporate
governance
With heightened corporate governance standards for
public companies and increased liability exposure, the
board of an IPO-bound company should include a mix
of audit, governance, compensation and compliance
specialists, as well as experienced executives. Typically,
small-cap company boards should aim for five to six
outside directors with a minimum of three independent
committees (audit, compensation and governance/
nominating). Directors must be able to meet a
substantial time commitment of 200 hours or more per
year, and companies must be able to draw a definitive
line between directors’ duties and the responsibilities
of executive management. Finally, the company should
develop a deep executive bench and an appropriate
succession plan.
A company considering an IPO also needs a strong set
of external advisors with significant experience in taking
companies public. The selection of a well-regarded
team of financial and tax advisors, auditors, attorneys
and underwriters carries significant weight with
investors. These experienced professionals can help
the company anticipate bumps in the road and resolve
difficult issues before they are raised externally.
Finally, the CEO and CFO are very important to
investors. The CFO must be able to communicate the
company’s financial results effectively to the investor
audience. And the CEO must be able to articulate the
company’s vision and strategy, as well as execute the
business plan and forge good relationships with all
external stakeholders.
Inform and communicate to potential
investors
Assemble a solid infrastructure
A highly skilled investor-relations professional —
whether in house or on retainer — is essential to
help guide a company’s strategic communication
plan in preparation for an IPO. He or she should be
able to draw the market’s interest and attract sell-side
coverage and potential investors. The investor-relations
professional should also be able to manage the risks
associated with the external messaging. Once the
company has gone public, he or she will have to
continually retell the company’s story and fine-tune
the investment value proposition, as well as provide
the appropriate guidance on milestones and financial
performance.
Because of the risks and regulations associated with
life as a public company, a financial, technological and
risk management infrastructure must be built, and the
right systems, procedures and controls put into place
well before an IPO.
Often, newly public companies find it a challenge to
produce quarterly financial statements. We recommend
that companies prepare their financial statements as
if they were already public for several quarters prior to
the IPO.
8

11. Orchestrate a successful road show
There will always be factors outside of the company’s
control — including volatile behavior on the part of the
stock market, consumers and the larger economy —
that affect operating performance. It is doubly important,
therefore, that a company about to go public focuses
on the factors it can control, such as managing the
business well, meeting revenue numbers and
creating value.
For the CEO and CFO, the most exhausting part of
going public is the pre-IPO road show, during which
they present the company to large investors. The road
show typically requires between 8 and 10 long days in
the US and an additional few days in Europe or Asia,
often with visits to multiple cities in a single day. It is
extremely important that despite this grueling schedule,
the company’s messaging remains consistent. A welldesigned road-show presentation with an “elevator
pitch” and talking points is essential. Management’s
presentation coaching and practice are crucial to road
show preparedness. Pre-IPO companies often consult
professional presentation training specialists to prepare
CEOs and CFOs for the unique requirements and rigors
of IPO road shows. The presentation team should plan
to rehearse formally a number of times before the first
day of meetings.
Preparing for an IPO is an intense and arduous process,
and it’s easy for management and employees to become
distracted by the enormity of the task. Company
leadership must strike the right balance between
managerial focus on the IPO transaction and the dayto-day operation of the company. They must remember
that preparedness can help lead to a successful IPO
outcome, but all of the best financial engineering will
not create business prosperity — only robust planning,
accurate expectations setting and strong operational
execution will forge the path to long-term success.
Attract the right investors and analysts
Conclusion: great public companies,
a great contribution
In order to drive a strong post-offering performance, the
company’s message must continue to resonate, even as
the investor pool expands to include thousands of new
investors. At first, many newly public companies enjoy
high share prices fueled in part by investors’ interest in
IPOs and by the press coverage for such companies.
However, unless this interest is carefully maintained after
the IPO, the initial euphoria will quickly fade.
Clearly, venture capitalists play an outsized role in
the American economy. They fund innovation and
improve productivity. Venture capitalists invest in the
cutting edge, in companies with revolutionary ideas
that have the potential to spawn whole new industries.
Companies should develop a plan for outreach to equity
analysts and shareholders — and actively cultivate a
dialogue with them, attend conferences and initiate nondeal marketing visits. Early engagement of investors and
analysts prior to the road show can help drive value and
avoid surprises.
Preparing for the IPO Value Journey®
1. Operate like a public company
2. Keep an open mind
3. Develop a brilliant sense of timing
Prepare to prove that you are true to
your word
4. Convene a superb team
5. Assemble a solid infrastructure
Once a company goes public, the real work begins:
keeping the promises made on the road show.
Management has to prove its credibility to investors by
using the proceeds of the public offering effectively and
executing the business plan. Companies that are about
to go public should clearly define the parameters and
metrics that analysts and investors can use in tracking
the progress of the business. Strong financial planning,
analysis and reporting are key.
6. Establish excellent corporate governance
7.
Inform and communicate to potential
investors
8. Orchestrate a successful road show
9. Attract the right investors and analysts
1 Prepare to prove that you are true
0.
to your word
9

12. It is no accident that although venture capitalists’
portfolio companies represent only a tiny fraction of
all new American firms, those companies create a
disproportionate share of the country’s employment.7
best possible outcome for entrepreneurs and for the
economy as a whole. Through an IPO, a promising
company can finance its growth while retaining
independence and a unique personality that might be
lost in an acquisition or other form of private purchase.
Arguably, however, venture capitalists make their
greatest contribution by helping to shape great public
companies. A well-managed IPO not only represents
the best possible outcome for venture capitalists and
their limited partners, but also may well represent the
By so successfully launching their portfolio companies
into the public markets, venture capitalists regularly
add new iconic enterprises to our market landscape
— many companies with such strong identities and
transformative products they change the world for
the better. 
7 Manju Puri and Rebecca E. Zarutskie, “On the Lifecycle Dynamics of VentureCapital- and Non-Venture-Capital-Financed Firms,” The Journal of Finance,
http://www.afajof.org/journal/forth_abstract.asp?ref=708, accessed
July 19, 2012.
About the Authors
Jacqueline A. Kelley (jacqueline.kelly@ey.com), Partner, is the Americas IPO Leader, Ernst Young LLP.
Bryan Pearce (bryan.pearce@ey.com), Partner, is the Americas Director, Entrepreneur Of The Year® and Venture Capital
Advisory Group, Ernst Young LLP. Ernst Young refers to the global organization of member firms of Ernst Young
Global Limited, each of which is a separate legal entity.
Ernst Young Global Limited does not provide services to clients. Ernst Young LLP is a client-serving member firm
operating in the US. The views expressed herein are those of the authors and do not necessarily reflect the views of
Ernst Young LLP.
10

13. Midstream Shareholder Liquidity
Alternatives: Structuring Shareholder
Take-Outs in Growth Equity Financings
By Dan Meehan and Alfred L. Browne of Cooley LLP
I. Introduction
The recent increase in private financing transactions
with a dividend, redemption, secondary sale, or other
“take-out” component is well documented. Once the
province of a relatively limited subset of sponsors
and targets, the so-called “recap” financing has gone
mainstream. Reliable data tracking the number of such
transactions is somewhat scarce. But over the past
three years, the percentage of financing transactions
handled by our firm with a liquidity component has
increased dramatically. With potential increases to
capital gains tax rates on the horizon, we expect an
even greater focus on liquidity for transactions closing
through the end of 2012.
Take-out transactions take many forms. We focus
here on transactions in which the target company is a
corporation1 and remains intact as a legal entity, the
new investor acquires between 20% and 70% of the
company’s fully-diluted ownership, and a significant
portion of the investment dollars end up in the hands
of the company’s existing stakeholders. This article
will explain the typical structuring alternatives for these
transactions, the key tax considerations for the various
potential participants, and certain other important
considerations.
For purposes of illustration, several examples are
provided. Unless otherwise indicated, the examples
assume the facts below. For brevity and ease of
1 Although the basic structuring alternatives for a non-corporate transaction are
the same, the tax consequences of a transaction involving a partnership or
limited liability company can differ dramatically for both existing owners and
the new investor.
11

14. Historically, recap
transactions were most
often a liquidity opportunity
for founders. More recently,
the primary objective of
the take-out is often
replacement of existing
investor ownership
with new investor
ownership.
II. Structuring Alternatives
Numerous structuring permutations are available for
financings with a liquidity component. This section
describes the most typical alternatives.
A. The Investor Transaction
New Investor’s transaction may take the form of an
investment in Company (or in some cases, a new entity
formed to acquire Company) in exchange for newlyissued (typically) preferred stock (a “primary” issuance)
or a direct purchase of outstanding stock from selling
stockholders (a “secondary” purchase). Occasionally, a
secondary purchase will be followed by New Investor’s
surrender of the acquired stock in exchange for newlyissued preferred or common stock.
In a primary issuance scenario, Company would
distribute a significant portion of the new money to
existing stockholders, as described in more detail
below. In a secondary transaction, the existing
stockholders will of course receive New Investor’s
money directly.
reference, we will employ the same capitalized names
and terms throughout the text.
• ompany is a corporation with 40 million shares
C
of stock outstanding:
o 0 million shares of Common Stock owned by
2
Founder, a U.S. individual who has owned his
shares for more than 1 year; and
B. Target Participants
o 0 million shares of Series A Preferred Stock
2
purchased for $1.00 per share by Original
Investor, a U.S. investment fund organized
as a limited partnership with various types of
partners including U.S. individuals, non-U.S.
persons and U.S. pension funds.
Recipients of the take-out dollars may include Original
Investor, Founder, Company option holders and other
Company employees. Sometimes all groups will
participate, sometimes only one. Historically, recap
transactions were most often a liquidity opportunity
for founders. More recently, the primary objective of
the take-out is often replacement of existing investor
ownership with new investor ownership.
Numerous considerations inform the decision about
which Company stakeholders participate in the takeout and how to allocate take-out dollars.
These include:
• ompany has issued employee options on 10
C
million shares of Common Stock with a strike
price of $.50 per share.
• he Series A Preferred Stock has a per share
T
liquidation preference of $1.00.
• ew Investor’s ownership requirements
N
(e.g., majority vs minority stake)
• ew Investor will invest $100 million to acquire
N
shares of Company stock.
• urrent owner willingness to relinquish a
C
controlling stake in Company
• ew Investor expects to own a majority of the
N
fully-diluted Company stock.
• emands for liquidity by Founder and
D
Original Investor
• ew Investor is willing to allow up to $80 million
N
of its investment to be paid to existing Company
owners and option holders, with up to $20 million
payable to Founder and up to $4.5 million payable
to option holders.
• illingness of both New Investor and company
W
management to allow employee participation,
taking into account the motivational pros and
cons of employee liquidity
• ompany’s operational funding requirements
C
12

15. C. The Participant Transaction
predetermined by agreement of Company’s board,
management and/or New Investor.
Participation of Company stakeholders in the take-out
can take any one or more of the following forms:
After the redemption is complete, New Investor will
own its desired percentage of Company, and the takeout participants will have achieved some measure
of liquidity with respect to their ownership stakes in
Company.
• ompany redeems outstanding stock by paying
C
cash to selling stakeholders
• Existing stockholders sell their outstanding
Company stock to the new investor for cash (a
“secondary” sale)
2. Secondary Sale of Outstanding Stock to New Investor
Although sellers often prefer the tax consequences
of selling their shares directly to a new investor,
recapitalization transactions are frequently structured
as a purchase by New Investor of newly-issued shares
from Company, followed by a redemption of Company
stock. There are a few key reasons for this:
• statutory cash-out merger with a “rollover” of
A
equity by continuing stakeholders
• ompany distributes cash (as a “dividend”) to
C
some or all holders
• Compensation paid to company employees
• s described above, in certain situations, the
A
tax consequences of a redemption can be more
favorable for one or more selling shareholders.
• loan from the company, sometimes coupled
A
with one or more options to acquire or sell stock
The transaction may also involve a recapitalization of
existing Company stock. For example, Company’s
Series A Preferred Stock might be reconstituted as
Common Stock, or existing Common Stock might be
subject to a reverse stock split.
• Typically, the business deal is that the new
investors will acquire a series of preferred
stock that has different terms from the existing
preferred stock.2
1. Redemption
In a take-out structured as a redemption, New Investor
typically will invest money directly into Company,
generally in exchange for the Series B Preferred Stock,
and Company will use some or all of the investment
dollars to redeem existing Company shares. Existing
stockholders may be given the option to elect to
participate in the take-out, or the participants may be
2 This sometimes can be achieved by first purchasing outstanding shares
directly from the sellers and then exchanging the purchased shares for the
new series of preferred stock. It can also be accomplished by reconstituting
the purchased shares as a new series of preferred stock. However, a primary
purchase from Company followed by a redemption typically is a more direct and
straightforward route from a corporate law, mechanical and tax perspective,
whereas the mechanics of exchanging or reconstituting shares often involves
numerous steps, more nuanced fiduciary considerations and the involvement of
more stakeholders. These considerations are discussed in Part IV.
13

16. A key issue in any redemption transaction is
whether stockholders’ surrender of outstanding shares
in exchange for cash will be treated as a “distribution” with
respect to their remaining stock of Company, or will instead
be treated as a sale or exchange of the
redeemed stock.
• ergerSub merges with and into Company.
M
Company is the surviving entity in the merger.
• ew Investor may prefer to deal with only one
N
entity (the corporation), rather than numerous
individual sellers.
• ewco acquires all of Company’s remaining
N
shares in the merger in exchange for cash paid to
Company’s stockholders.
However, a secondary sale sometimes is used –
either because it is most tax-efficient for the selling
stockholders, or because New Investor does not
demand a new series of stock, or simply because New
Investor and the sellers prefer to negotiate the terms
of their transaction with minimal interference from
Company.
4. Dividend
Instead of using New Investor’s funds to redeem
Company’s existing shares, Company could use
those funds to declare and pay a dividend on existing
shares. Depending on Company’s charter or articles of
organization, a dividend could be paid on Company’s
existing common stock, preferred stock or both.
Sometimes, a secondary purchase will be followed by
an exchange. For example, if New Investor purchases
Common Stock and Series A Preferred Stock, New
Investor might immediately exchange that stock for
newly-issued Series B Preferred Stock.
By declaring a dividend, Company can provide a
certain amount of liquidity to everyone owning the
classes of share receiving the dividend. While this
solution can mitigate some issues involved in picking
participants for an oversubscribed take-out, it also can
end up providing liquidity to investors that may not
otherwise demand it.
3. Cash-Out Merger
A statutory cash-out merger may be utilized in cases
where it is not possible to easily obtain signatures
from all of the participating Company stockholders
(as would be required in a more straightforward
sale transaction), either due to the number of
existing Company stockholders or because certain
stockholders may be unwilling to sign. Such a merger
transaction is often structured in the following manner
(or some variation thereof):
5. Compensation Paid to Company Employees
Company could use New Investor’s funds to pay
bonuses to certain Company employees. If only
employee shareholders are seeking liquidity, a bonus
can put cash in their hands without going through
the process of declaring and paying a dividend or
redeeming stock. The bonuses would be run through
Company’s payroll procedures and could be made
disproportionately without any effect on Company’s
ownership structure.
• ew Investor organizes a new entity to be the
N
acquirer (“Newco”) in the merger and makes its
investment into Newco in exchange for newlyissued Newco preferred stock.
• ertain Company stockholders contribute their
C
existing Company stock to Newco in exchange
for newly-issued Newco stock having (usually) the
same rights as the contributed Company stock.
6. Combination
Sometimes Company might choose to use a
combination of compensation and redemption to
achieve all of the stakeholder’s goals. With this option,
Company can reorganize its capital structure through
• ewco forms a wholly-owned “shell” subsidiary
N
(“MergerSub”).
14

17. the redemption portion of the take-out and also issue
compensation to the extent it wants to reward certain
employees beyond the value of those employees’
redeemed shares.
different – and sometimes very sophisticated – tax
considerations. Those considerations are beyond
the scope of this article, but should be addressed
with a tax advisor before any of these variations are
implemented.
7. Treatment of Stock Option Holders
III. Tax Considerations
Company may also want to provide liquidity to its
option holders in a take-out. There are a few different
ways to do this:
A. Redemption
The key tax issues that may arise as a result of
a redemption transaction in connection with a
recap financing are discussed below. To aid in the
explanation, we will refer to the following sample facts:
• ermit option holders to exercise all or a portion
P
of their options (either through payment of the
exercise price or through a “cashless” exercise),
allowing them to participate as stockholders in the
liquidity transaction; or
Example 1
New Investor will pay its investment dollars to Company
in exchange for newly-issued Series B Preferred Stock.
Company will use $75 million of New Investor’s invested capital
to redeem a portion of its outstanding equity, as follows:
• ermit option holders to surrender all or a
P
portion of their unexercised options in exchange
for liquidity proceeds calculated based on the
difference between the option exercise price and
the fair market value of the underlying stock.
• 5 million shares of Series A Preferred Stock redeemed at a
1
$3.37 per share price ($50.5 million total);
• 0 million shares of Common Stock redeemed at a $2.00
1
per share price ($20 million total); and
8. Other Liquidity Options
Of course, the alternatives for structuring cash
transfers to existing Company owners are not limited
to those described in this article. For Founder and
key employees, in particular, numerous alternative
approaches (from the simple to the very creative) have
been utilized over the years. For example:
• ptions on 3 million shares, netting $1.50 per option share
O
after deduction of strike prices ($4.5 million total).
1. Distribution vs Sale Treatment – Why it Matters
A key issue in any redemption transaction is whether
stockholders’ surrender of outstanding shares in
exchange for cash will be treated as a “distribution”
with respect to their remaining stock of Company,
or will instead be treated as a sale or exchange of
the redeemed stock. The determination of sale or
distribution treatment is explained below. But first, it
is important to understand the stakes involved in this
question. They include:
• ew Investor or Company might loan money to
N
Founder. Typically, the loan would be secured by
Founder’s Common Stock. The loan may be fully
recourse, fully nonrecourse, or partial recourse.
• loan coupled with a call option on Founder’s
A
company stock. In this variation, New Investor
is typically the lender and holds the call option.
Often, the call option cannot be exercised for
some period of years, and the strike price of the
option may be significantly higher than the current
value of the Common Stock, reflecting the parties’
expectations (or at least hopes) about the future
value of that stock. Typically, the loan in this
approach would be fully (or mostly) nonrecourse.
In some cases, Founder may also have a put
option, effectively creating a “collar” on the
Common Stock.
• or U.S. individuals (including U.S. individual
F
partners of an investment fund), whether (or
at least when) basis in Company’s stock can
be used to reduce taxable income from the
transaction, as well as the tax rate applicable to
the transaction.
• or non-U.S. shareholders (including non-U.S.
F
partners of an investment fund), whether U.S.
withholding tax will be imposed in connection with
the transaction.
Other variations are also possible, including a “prepaid
forward” sale of the stock. Each variation (and each
component choice within each variation) involves
• or U.S. corporate shareholders, whether a
F
“dividends received deduction” is available to
reduce tax from the transaction.
15

18. In Example 1, Original Investor may have limited
partners comprising all three of the above categories
(U.S. individuals, U.S. corporations and non-U.S.
persons). While U.S. corporate partners of Original
Investor may have a preference for distribution
treatment because of the possible dividends received
deduction, non-U.S. partners often will prefer sale
treatment because sale treatment generally will avoid
U.S. withholding tax for their share of the redemption
proceeds. If distribution treatment applies and if some
or all of the “distribution” is treated as a dividend for tax
purposes (as explained further below), Original Investor
typically would be required to withhold U.S. withholding
tax with respect to its non-U.S. partners’ share of the
dividend income at rates up to 30%.3
distribution for Original Investor, then its actual
tax consequences are determined based on a threetiered filter.
First, if Company has current or accumulated “earnings
and profits” (or “EP”) 4 then the distribution would result
in dividend income for Original Investor up to Original
Investor’s allocable share of the EP.5 Original Investor
may not use its basis in the shares to offset the dividend
income.
Second, if Original Investor’s redemption proceeds
exceed its share of Company’s current and accumulated
EP, the next redemption dollars are treated as a taxfree return of basis up to Original Investor’s basis in
its Company shares. In some cases, this may cause
Original Investor and its partners to prefer distribution
treatment. Under this second tier of the analysis,
Original Investor may use its basis in both the redeemed
shares and its retained shares. As compared to sale
treatment, this potentially allows Original Investor to
receive an additional $5 million of redemption proceeds
free of tax. For example, if Company has no current or
accumulated EP, Original Investor would presumably
prefer distribution treatment, which would allow
Original Investor to receive $20 million of its redemption
proceeds free of federal income tax. Under sale
treatment, Original Investor may use only its $15 million
basis in the redeemed shares as an offset.
U.S. individuals often prefer sale treatment because of
the ability to use their basis in the redeemed shares to
offset taxable income from the transaction. In Example
1, Founder has no basis in his shares of Common
Stock, having received those shares for future services
upon Company’s inception when they had no value.
In addition, Founder is eligible for the 15% federal tax
rate on “qualified dividends,” the same rate that would
apply to long-term capital gain he would recognize on
a sale of his shares. Accordingly, Founder is likely to be
indifferent as between dividend and sale treatment for
his redemption. On the other hand, Founder may prefer
sale treatment if he lives in a state with a reduced tax
rate on capital gains or if federal income tax rates on
dividend income increase.
Third, if Original Investor’s redemption proceeds exceed
both its share of Company’s EP and its entire $20
million tax basis in the Series A Preferred Stock, then
any remaining redemption proceeds will be treated as
capital gain. If Company has no current or accumulated
EP, Original Investor would have $30.5 million of
capital gain under distribution treatment, as compared
to $35.5 million under sale treatment.
In contrast to Founder, U.S. individual partners of
Original Investor likely will not be indifferent as between
sale and distribution treatment. Original Investor has an
aggregate basis of $15 million in its redeemed shares. If
sale treatment applies, Original Investor will recognize a
tax gain on the sale of $35.5 million – that is, its $50.5
million of “sale” proceeds less its $15 million basis in
the redeemed shares. Because of Original Investor’s
ability to utilize its $15 million basis to reduce its gain
under sale treatment, Original Investor’s U.S. individual
partners may well prefer sale treatment to distribution
treatment.
2. Determining Distribution vs Sale Treatment
Determining whether a redemption should be classified
as a distribution or a sale is equally complex, and
not entirely objective in every case. However, certain
4 There is no clear definition of EP in the tax code. It is not synonymous with
either taxable income or GAAP retained earnings. However, it is often relatively
close to the corporation’s net taxable income (or loss), as reduced by previous
dividends distributed by the corporation. Dividend treatment may apply if Company
has either current-year EP, or EP for all prior years combined. Thus, dividend
treatment may apply even if Company has no accumulated EP (for all prior years
combined), if Company has EP for the current year viewed in isolation.
5 Each shareholder of a corporation will be allocated a certain portion of the
corporation’s EP based on the relative ownership and distribution rights inherent
in their stock.
However, in some situations, U.S. individuals may prefer
distribution treatment. If the redemption is treated as a
3 The actual withholding tax rate for a given partner of Original Investor will depend
on the partner’s home country residence and on whether that country has a tax
treaty with the U.S. that reduces the regular withholding tax rate on dividends.
16

19. objective safe harbors are available. A complete
redemption of a shareholder’s interest in a corporation
is one safe harbor (although even this test is not as
simple as it sounds, due to the potential application
of certain share ownership “attribution” rules). The
“substantially disproportionate” redemption is another
safe harbor. Under this test, the shareholder’s
percentage ownership of both outstanding common
stock and outstanding voting stock after the
redemption must be less than 80% of its percentage
ownership prior to the redemption. Various other
nuances apply, including certain stock ownership
attribution rules and a requirement that, immediately
after the redemption, the stockholder must own less
than 50% of the corporation’s total voting power.
In Example 1, Original Investor’s initial commonequivalent and voting percentage of the outstanding
stock is 50%. To qualify for the substantially
disproportionate test, Original Investor’s ownership
after the redemption must be less than 40% (i.e., less
than 80% of 50%). In the above example, Original
Investor’s percentage of the outstanding commonequivalent and voting power after the redemption
is approximately 14% and therefore satisfies the
substantially disproportionate test, meaning Original
Investor’s redemption should be treated as a sale
of shares for income tax purposes, rather than a
distribution.
Similarly, Founder’s percentage ownership of
the outstanding stock decreases from 50% to
approximately 29% after the redemption and should
also qualify as substantially disproportionate. As noted
above, Founder may be indifferent as to whether the
redemption is treated as a sale or redemption for
tax purposes.
If neither the “substantially disproportionate” nor the
“complete redemption” safe harbors are available, a
redemption may in some cases still be classified as
a sale for income tax purposes if it is “not essentially
equivalent to a dividend.” However, this analysis is
based on the facts and circumstances of each case
rather than on objective criteria. The case law generally
requires a “meaningful” reduction in the stockholder’s
interest in the corporation, but the courts and the
IRS have varied interpretations of what qualifies as
“meaningful.” Accordingly, tax practitioners prefer
not to rely on this category in advising on the tax
consequences of redemptions.
17

20. In contrast to redemptions,
the tax consequences of
a direct sale of stock by
existing stockholders to
New Investor are often
straightforward.
practitioners identify as relevant in determining whether
redemption proceeds may be characterized in whole
or in part as compensation. These include:
• ll available information about the valuation of the
A
Common Stock.
• he expected financial accounting treatment of
T
the redemption price paid to employee-sellers.
• hether the redemption price for the Common
W
Stock is viewed as an arm’s-length, negotiated
price.
• hether any portion of the Common Stock is
W
being sold by persons who provide no services
to Company (for example, if Original Investor also
held Common Stock and was selling it to New
Investor at the same price as Founder).
3. Possible Recharacterization
In addition to determining the general tax treatment of
a redemption as either a sale or distribution, in some
cases a redemption transaction may raise other tax
characterization questions. In particular, if Company
redeems shares held by employees, there may be a
question about whether some or all of the redemption
price could be characterized as compensation for
tax purposes. This is usually a somewhat subjective
analysis and can be a very sensitive and important
issue for both the selling employees and the company.
• hether dividend treatment might be a more
W
appropriate recharacterization than compensation.
The tax analysis should take into account all of the
foregoing factors.6
In cases where some or all of the redemption price
payable to employee-sellers is determined to be
compensation, the redemption payment mechanics
should be revised for the compensation portion of the
payments. The compensation portion should be run
through Company’s payroll processing procedures
(internal or external). Income tax withholding and
employment taxes should be withheld from that
portion of the payment. The resulting amount (net of
withholding) can then be paid to the employee sellers.
Of course, any portion of the amounts payable to
employee-sellers that is determined to be equal to the
true fair market value of Company’s Common Stock
can be paid outside those compensation procedures.
For Company, one key question is whether a tax
withholding obligation may exist with respect to
some or all of the payments to employee sellers.
The tax deductibility of such payments will also
be a consideration for Company. A payment of
compensation is deductible by Company, whereas
the redemption price for stock is not. For the selling
employees, compensation treatment usually will result
in a significantly higher tax burden for the transaction
proceeds, given that compensation is taxed at federal
income tax rates up to 35% (possibly increasing in the
future) and is subject to employment taxes as well.
The compensation question often arises in situations
where the redemption price to be paid for – in our
examples – Company Common Stock is equal to (or
very close to) the price being paid by New Investor for
Series B Preferred Stock. This situation highlights the
question because the Series B Preferred Stock has
economic features (such as a liquidation preference
and dividend rights) and other rights that seemingly
make it far more valuable than the Common Stock.
On the other hand, in many cases, all the parties to
the transaction believe that the agreed redemption
price for the Common Stock does represent its true
fair market value. There are several factors that tax
Example 2
Assume Company’s board of directors determines (by
commissioning an independent appraisal) that the fair market
value of Company’s Common Stock is $1.75 per share, rather
than the $2 per share Company will pay to redeem that stock.
Company’s board determines based on consultations with tax
counsel that the excess portion of the payment for Founder’s
Common Stock will be treated as compensation to Founder.
Founder is being paid $2 per share, so $0.25 per share will be
considered compensation.
6 Tax practitioners may occasionally consider the relative incentive of a taxing
authority to characterize the common stock redemption price as compensation.
Sometimes, the overall tax revenue generated by the transaction would be lower
with compensation treatment because of the resulting corporate tax deduction.
18

21. However, secondary sale transactions are not entirely
free from tax uncertainty. There still can be a question
about whether some of the purchase price payable to
employee-sellers represents compensation. This often
surprises transaction participants. Intuitively, it would
seem that if no payments are made by Company to
its employees, then no portion of the sale price could
be treated as compensation. Moreover, participants
often note that a price negotiated by unrelated buyers
and sellers should be respected as fair market value.
On the other hand, where the facts indicate that there
is some compensatory element to the agreed price
(based on the various factors described previously),
most tax practitioners believe that a taxing authority
would not be swayed merely by the “form” of the
transaction as a secondary sale. And certain tax
regulations support this belief.
• Redemption: Since the fair market value of the stock
is $1.75 per share, that portion of the payment will be
treated as a sale of Founder’s shares (assuming Founder’s
satisfaction of the “substantially disproportionate”
redemption test described above) and will be taxed at the
15% federal long-term capital gains tax rate, plus state
and local taxes. For purposes of this example, assume
a 10% state and local tax rate on both capital gains and
ordinary income. Thus, in this example, Founder will pay
$4.375 million in taxes on the “purchase” portion of his
proceeds. Since no withholding would occur for this tax
liability, Founder would be well advised to set aside funds
for payment of these taxes, either through estimated tax
payments during the remainder of the year or by the due
date for his tax return, at the latest.
• Compensation: As noted above, $2.5 million of the total
consideration payable to Founder is determined to be
compensation. Company will run this amount through its
payroll provider, deduct applicable income and employment
taxes, and remit the balance to Founder. Assuming federal
income tax is withheld at a 35% tax rate and all other
taxes (Medicare, state, and local)7 total an additional 12%,
approximately 47% (or $1.175 million) of the amount treated
as compensation will be withheld and remitted to the
applicable taxing authorities by Company. Also, Company
will be entitled to a tax deduction equal to the $2.5 million of
compensation. This deduction is often a significant windfall
to Company (assuming Company has net taxable income
against which to use the deduction) that was not anticipated
at the outset of the transaction and was created with no net
cash outflow from the Company. In some cases, the parties
may have originally expected that all of Founder’s payment
would be taxed as capital gain. In such cases, the board
of Company may consider paying Founder a “gross-up”
amount to cover the difference between compensation
taxes and capital gains taxes.
In cases where it is determined that some portion
of the secondary sale price does represent
compensation, it is usually easiest to restructure that
portion of the payment. Typically, this takes the form
of a payment by New Investor to Company, followed
by Company’s payment to the employee-sellers after
deduction of applicable withholding taxes. Often,
New Investor’s payment to Company is restructured
as the purchase price for newly-issued preferred
stock. In some cases, the parties may find it easier to
restructure the entire transaction as a primary issuance
of stock by Company, followed by a redemption
payment to selling shareholders.
B. Secondary Sale to New Investor
In contrast to redemptions, the tax consequences
of a direct sale of stock by existing stockholders
to New Investor are often straightforward. In our
example, if Original Investor sells 15 million shares to
New Investor for $50.5 million, Original Investor will
recognize a capital gain of $35.5 million, which is the
difference between the $50.5 million purchase price
and Original Investor’s $15 million tax basis in the
15 million shares sold. As noted above, this typically
will be Original Investor’s preferred tax outcome
(as compared to distribution treatment). Similarly, if
Founder sells 10 million shares directly to New Investor
for $20 million, Founder likely will recognize a capital
gain of $20 million.
Example 3
Instead of purchasing newly-issued stock from Company,
New Investor purchases already outstanding shares from
Founder. Assume also that Company Common Stock has an
objectively determined fair market value of $1.75 per share
and that the parties, including Company’s board of directors,
determine that the excess $.25 per share payable to Founder
represents compensation due to Founder’s status as a key
employee.
• reatment of the Purchase of Founder’s Common Stock:
T
In this situation, rather than having New Investor pay the
entire $2 per share directly to Founder, a better approach
is typically to bifurcate the investment as follows:
7 This assumes that Founder’s other compensation exceeds the wage base limit
for Social Security taxes.
19
o 17.5 million paid directly to Founder in exchange
$
for 10 million shares of Founder’s common stock at
$1.75 per share; and
o he other $2.5 million paid to Company in exchange
T
for a primary issuance of Company stock (most likely
the Series B preferred stock described in the Base
Example, rather than additional common stock).

22. tax analysis of a rollover depends in part on whether
Newco is a corporation or an entity classified as a
partnership for income tax purposes (typically a limited
liability company, or “LLC”). If Newco is an LLC, the
rollover usually can be structured as a nontaxable
transaction.
Company would then process the $2.5 million through
payroll as a compensatory bonus to Founder in the same
manner discussed in Example 2 above. The ultimate tax
results of this approach for Founder and Company would
be equivalent to those described in Example 2. However,
New Investor may be unwilling to hold the common stock
purchased from Founder and may require that the common
stock be exchanged for new Series B Preferred Stock.
If Newco is a corporation, the rollover participants
and New Investor together must own at least 80% of
Newco’s voting power and total stock value in order
for the rollover to be eligible for nontaxable treatment.
However, “nontaxable” treatment for a rollover to
corporate Newco is not necessarily what it seems.
Depending on various factors, a rollover participant
who also receives some cash in the merger may end
up with approximately the same overall tax liability as
if the rollover were a fully-taxable transaction, even if
the rollover itself satisfies the 80% test. Again, a full
explanation of this phenomenon is beyond the scope
of this article.
As noted in Part III.A.1 above, a secondary sale might
facilitate a better (or worse) tax result for Original
Investor or Founder, depending on various factors.
Example 4
Assume now that Original Investor agrees to sell fewer
shares – only 2.5 million shares of Series A Preferred Stock
– in the transaction. If the transaction is structured as a
primary issuance to New Investor followed by a redemption
from Original Investor, Original Investor’s percentage of
outstanding voting stock and common equivalents after the
transaction would be approximately 44%. This reduction in
Original Investor’s percentage from 50% to 44% would not
satisfy the “substantially disproportionate” test explained
in Part III.A.2 above. Accordingly, some or all of Original
Investor’s redemption may be characterized as a dividend,
meaning Original Investor is reducing its tax liability on that
portion of its proceeds by offseting those proceeds with
a portion of its tax basis in the Series A Preferred Stock.
However, if the transaction were structured as a secondary
sale of Series A Preferred Stock directly to New Investor,
Original Investor could use a portion of its tax basis to
reduce the taxable amount. This may create tension between
Original Investor’s desire for a better tax outcome by selling
Series A Preferred Stock to New Investors, and New
Investor’s preference for purchasing Series B Preferred Stock
with different rights and privileges. Alternatively, New Investor
may be able to exchange Series A Preferred Stock with
Company for newly-issued Series B Preferred Stock; or New
Investor may be indifferent to the type of stock purchased
because of its expectations about Company’s current value
and future prospects.
D. Dividend
Most of the tax considerations applicable to a dividend
payment are addressed above in Part III.A. As noted
above, Company’s dividend of cash may represent a
nontaxable return of stockholder basis in Company
stock or may be taxable as dividend income. A special
low federal income tax rate (15% under current law)
applies to “qualified” dividend income received by
individuals.8
As with redemptions and secondary sales, a dividend
may raise the question of compensation treatment
for employee-stockholders. However, the tax analysis
is somewhat different because a dividend does
not involve a sale of shares – either in form or in
substance. Accordingly, the question of valuation is
less relevant in this context. Rather, the tax analysis
focuses on the rights of the parties to dividend under
the corporate charter, relative shareholdings, arm’slength compensation and other factors. Arguably,
a dividend structure renders the already subjective
compensation analysis even less clear. Depending
on the circumstances, there may be less inclination
to recharacterize a dividend as compensation than in
other contexts both on the part of tax advisors and
C. Cash-Out Merger
The tax issues arising in a cash-out merger transaction
are particularly complex, and a full discussion of those
issues is beyond the scope of this article. Depending
on the precise structure used, the cash paid in a cashout merger may be treated as “sale” proceeds for tax
purposes, or as “redemption” proceeds (which in turn
may result in dividend income, recovery of basis or
capital gain), or as so-called “boot” in a stock rollover
transaction, each with their own unique tax results.
Perhaps the most critical question in such a
transaction is whether the “rollover” component will
be tax-free to the rollover participants. Because this
component involves the exchange of Company stock
for illiquid stock of Newco, it is typically important to
the participants that the rollover be nontaxable. The
8 In order to qualify, the stock on which the dividend is declared must be held by
the stockholder for more than 60 days during the 121-day period beginning on
the “ex-dividend” date (generally, the last date on which one must have owned
the stock in order to become eligible for a declared dividend).
20

23. F. Tax treatment of payments to stock option
holders
taxing authorities. On the other hand, if dividend tax
treatment would result in wholly or mostly tax-free
proceeds (because the company has no EP and the
dividend recipients have tax basis in excess of the
dividend amount), one should take into account the
increased incentive of a taxing authority to challenge
dividend treatment in such circumstances.
If Company option holders do participate in the
proceeds of a take-out transaction, it is often most
convenient to simply pay them in exchange for their
agreement to cancel a portion of their unexercised
stock options. This approach does not require the
employee to write a check for the option exercise
price, or the issuance of stock certificates.
Example 5
Assume now that Company will not redeem any shares
of its stock, but will pay out $40 million of New Investor’s
investment as a dividend to Founder and Original Investor.
Assume $30 million of this amount is distributed to Original
Investor and $10 million is distributed to Founder. Also
assume that Company has $20 million of current year EP
and no accumulated EP.
Payments to employee option holders for unexercised
stock options will always be characterized as
compensation for tax purposes, and tax withholding
will apply whether the options in question are so-called
“incentive stock options” (commonly referred to as
“ISOs”) 9 or “nonstatutory stock options.”
Founder Common Stock Treatment: Even though Company
may have no accumulated EP, the $20 million of current
year EP will render a portion of Founder’s distribution
taxable as dividend income for tax purposes. Assume 25% of
the current year EP is allocable to Founder (i.e., $5 million)
and therefore that $5 million of Founder’s distribution will be
taxed as a dividend. If Founder had tax basis in his shares,
the other $5 million would first reduce Founder’s basis
before being treated as capital gain. In this case, because
Founder’s basis in his shares is $0, the other $5 million will
be taxed as long-term capital gain. Because dividends and
long-term capital gains are currently taxed at the same 15%
federal tax rate, and assuming 10% state and local tax,
Founder’s dividend will be subject to aggregate tax of $2.5
million. Again, since this tax is not withheld by the Company,
Founder should consider setting aside a portion of the
distribution to cover taxes when they become due. In future
years, if the federal dividend rate and capital gains rate vary,
Founder may find this dividend approach to be a less taxefficient liquidity alternative.
On the other hand, employees who hold ISOs should
at least consider whether tax savings can be achieved
by first exercising their ISOs and then participating in
the liquidity transaction as a stockholder. For example,
if the liquidity transaction is structured as a secondary
sale directly to the new investor or as a redemption
of shares qualifying as a “sale” for tax purposes, the
exercise of an ISO followed shortly thereafter by a sale
of the underlying shares will be treated as a so-called
“disqualifying disposition.” Although this approach
results in the same federal income tax rate as the net
“cash-out” approach described above for unexercised
options, the exercise of an ISO and sale of the ISO
shares allows the employee to avoid income tax
withholding and employment taxes. Employees who
use this approach will need to plan appropriately for
payment of the income tax by the time they file their
income tax returns for the year of the payment (at the
latest), and in some cases may need to make interim
estimated tax payments in order to avoid interest
penalties.
Old Investor Series A Preferred Stock Tax Treatment:
Assume Company’s remaining EP ($15 million) is allocated
to Old Investor and therefore $15 million of Old Investor’s $30
million distribution will be treated as a dividend for income
tax purposes. Old Investor’s partners will be subject to the
disparate tax treatment for dividends discussed in Part III.A.1.
above (U.S. individuals subject to federal tax of 15%; nonU.S. persons subject to US tax withholding at rates up to
30%; and U.S. corporations may be able to benefit from a
“dividends received deduction”). The other $15 million of Old
Investor’s dividend will be treated as a tax-free recovery of
Old Investor’s basis in its Series A Preferred Stock (reducing
that basis from $20 million to $5 million.
However, in some cases, exercising an ISO may not
be the optimal approach. ISOs generally must be
exercised with a cash payment (rather than through
a cashless exercise). And, if the liquidity transaction
is structured as a distribution taxed as a dividend,
the option holder may end up triggering alternative
E. Compensation paid to company employees
The tax implications of a payment intentionally
structured as compensation to Company employees
are addressed elsewhere in this article. The payment
generally should be run through the company’s payroll
procedures and applicable taxes should be withheld.
9 ISOs are employee stock options that meet certain requirements and qualify for
special tax treatment under the Internal Revenue Code.
21

24. IV. Other Considerations
minimum tax (“AMT”) by exercising the ISO10 and may
be taxed at the same time on the dividend income.
Thus, exercising an ISO may result in 3 layers of cash
cost for the employee – the exercise price, AMT and
the dividend tax. The liquidity amount may or may not
cover the entire cash outlay. Accordingly, the decision
to exercise an ISO as part of such a transaction should
be made only with the help of a tax advisor.
Although this article focuses primarily on structure
and tax considerations, additional issues must be
considered. In a “take-out” transaction structured
as a redemption, Company’s board of directors
must consider the advisability of issuing the Series
B Preferred Stock in the first instance, and then the
advisability of using the proceeds to repurchase
existing shares. Often, there are several legitimate
reasons for approving these transactions, including
the need to align Original Investor (and possibly
Founder) with the strategic plan adopted by the
board and management. Stockholders who are no
longer interested in Company as an investment, who
require very near-term liquidity, or who simply do not
“buy-in” to management’s strategy will often disrupt or
otherwise negatively impact the management team’s
efforts. A prudent board will seriously consider a
liquidity transaction to minimize these disruptions and
negative effects.
Example 6
Company will allow option holders to participate in liquidity
proceeds (for options on up to 2 million shares) by either
surrendering unexercised options for their net “spread” value
or exercising their options and participating in the transaction
as stockholders. All the options are ISOs. The ISOs have an
exercise price of $0.50 per share, so $1.50 will be paid for
each unexercised option surrendered.
Certain option holders wish to avoid employment taxes on
their proceeds for 1 million option shares). Those employees
pay $500,000 to Company a few days in advance of the
liquidity transaction. In the transaction, their 1 million shares
are redeemed by Company for a total of $2 million. Assume
the redemption qualifies as a sale for tax purposes.
Their sale of the ISO shares is a so-called “disqualifying
disposition.” The employees will owe ordinary income taxes
on the spread between their exercise price and the sale
price. Assuming a 35% federal income tax rate and a 10%
state tax rate, that would equate to approximately $675,000
of income tax on the $1.5 million of compensation income
the options holders recognize. However, assuming the
option holders’ wages are already above the Social Security
wage limit, the employees will avoid the Medicare tax.11 No
tax would be withheld from the payments to these holders.
Rather, they should consider setting aside $675,000 for
payment of the tax when it becomes due.
While there are often several legitimate reasons for
approving a “take-out” transaction, during the approval
process a board must also be mindful of self-interested
motivations and/or the appearance of impropriety.
Failure to do so may raise questions (and in some
cases, legal claims) from Company stockholders.
When the transaction is structured as a redemption
of shares held by insiders (including investment funds
affiliated with board members), courts will often
scrutinize these transactions more carefully. If liquidity
is available only to a select group of stockholders,
Company’s board should be prepared to justify the
rationale for the limitation. Often, in order to avoid the
appearance of impropriety, a board will require that the
redemption be made available to all holders of capital
stock on a pro rata basis, with a nondiscriminatory
“cut-back” mechanism if participation is oversubscribed. However, by making the redemption
available to a broader number of individuals or entities,
the securities law rules for tender offers may be
implicated – adding an additional level of complexity to
the transaction.
The employees who accept $1.5 million in exchange for
cancelling unexercised options on 1 million shares will owe
the same amount of income tax (assuming the same income
tax rates), plus Medicare tax (and Social Security tax, if
applicable), which would be withheld from the $1.5 million.
10 The alternative minimum tax may ultimately be offset against capital gains taxes
in a future sale of the shares, but if the future sale is a loss for tax purposes, the
AMT may never be fully recovered.
11 At the current 1.45% Medicare rate, the employees would save $21,750, and
the Company would save an equal amount. The Medicare rate is scheduled to
rise for some taxpayers, beginning in 2013.
22

25. While there are often several legitimate reasons for
approving a “take-out” transaction, during the approval process
a board must also be mindful of self-interested motivations
and/or the appearance of impropriety. Failure to do so
may raise questions (and in some cases, legal claims)
from Company stockholders.
The considerations applicable to a take-out transaction
structured as a secondary sale are similar, but not
entirely the same. In many cases, Company will not
be involved in the decision to sell or set the sale price,
and Company may try to avoid becoming involved
in the process. The board’s actions are less likely to
be scrutinized if Company is only minimally involved.
Company’s involvement may be limited to approval of
an exchange of Series A Preferred Stock or Common
Stock purchased by New Investor for newly-issued
Series B Preferred Stock, and the authorization
and issuance of the Series B Preferred Stock.
Company may be required to disclose more extensive
information if there are several selling stockholders
and/or if the tender offer rules apply. Company may
determine that it is appropriate to prepare a disclosure
document. However, in many cases the board’s
fiduciary obligations will require a full analysis of the
factors listed above.
In summary, when approving a “take-out” transaction
structured as a redemption, a board should carefully
consider each of the following:
• hat is the corporate or business rationale for the
W
redemption/liquidity transaction?
• ho will benefit from the liquidity?
W
• re there any conflicts of interest around the
A
board table? Will any board members receive
significant proceeds in the transaction?
• s there a class or group of stockholders who are
I
not being offered the chance to sell their shares?
• t what price should Company repurchase
A
shares? How does this affect option pricing?
• ill Company have adequate capital to operate
W
If New Investor’s purchase of Series A Preferred Stock
or Common Stock is followed by an exchange for
newly-issued Series B Preferred Stock, other issues
arise, such as:
its business after the transaction? Does the
transaction satisfy state law limitations on share
repurchases and dividends?
• re there restrictions in Company’s contracts
A
• hether the board may, in the proper exercise of
W
its fiduciary duties, approve the exchange and/or
grant New Investor additional stockholder rights.
(including investor documentation and/or debt
documentation) that limit Company’s ability to
repurchase shares?
• hat the terms of the Series B Preferred Stock
W
should be.
• as Company satisfied its disclosure obligations
H
• hat the exchange ratio should be.
W
in connection with the repurchase?
• hether there is an effect on the valuation of
W
Company’s Common Stock and correspondingly
on the pricing of Company’s stock options.
• re there any compensatory payments being
A
made (or any deemed compensatory payments
being made)? Is Company satisfying its tax
• hether the exchange triggers any preexisting
W
rights held by Original Investor, such as rights of
co-sale, or rights of first refusal.
withholding obligations?
23

26. • he tax consequences of the exchange (both for
T
New Investor and possibly for Original Investor
and Founder).
Conclusion
A financing transaction with a stockholder liquidity
component generates opportunities to rationalize a
company’s capital structure; bring in new investors
with fresh ideas, energy and capital to move the
company forward; provide liquidity for founders and
other stakeholders; take advantage of various tax
benefits; and eliminate or diminish the presence of
distractive stakeholders. These transactions also
involve potential costs and complexities – both tax
and nontax. Accordingly, such transactions must be
carefully planned, and counsel should be consulted
early in the process to identify and work through the
potential opportunities and traps. 
About the Authors
Dan Meehan is a partner with Cooley LLP. He is based in New York and is Chair of the firm’s Tax Group. His practice
focuses on structuring and tax counseling for private equity, leveraged buyout and MA transactions. He regularly
advises financial investors, strategic buyers and target companies, with an emphasis on the software, technology,
government services and life sciences sectors. He also helps businesses optimize their operational tax structure and plan
for the tax aspects of future financing and exit transactions.
Al Browne is the partner in charge of Cooley LLP’s Boston office and Chair of the firm’s growth equity practice group.
Al specializes in mergers and acquisitions; late-stage venture capital and growth equity transactions; cross-border
transactions; and complex intellectual property transactions, particularly in the software industry. His clients include
strategic and financial buyers and sellers in public and private acquisitions, among them private-equity-sponsored
leveraged buyouts and take-private transactions. Al also has significant experience in counseling boards of directors in
connection with mergers and acquisitions and related governance and anti-takeover matters.
The authors appreciate the assistance of Jonathan Rivinus, an associate in Cooley’s Tax Group.
24

27. Contingent Consideration:
Does it Have Value?
By Steven Nebb, CFA and David L. Larsen, CPA, Managing Directors of Duff Phelps LLC
In an environment of greater regulation and increasing
transparency, most venture capital managers have
come to grips with the accounting requirement to
report all investments at fair value. They may not like
the requirement, but generally they understand that
most LPs must have fair value information to monitor
investments, allocate capital and prepare their own
financial statements.
A phenomenon of the current economic and
technological environment is the increasing use of
consideration dependent upon future events, as a
strategy for exiting an investment. The contractual
right to future consideration can be very beneficial,
especially for deals encircled with uncertainty; where
significant potential value of a business lies in the
outcome of future events. The contractual right to
future consideration is often described as “contingent
consideration.”
Negotiating a contract for future consideration allows
sellers to close a deal with the ability to realize a
price they think is fair, taking into account future
performance they deem both valuable and likely, but
that has not yet been achieved. For buyers, the ability
to contractually delay paying for value before it fully
crystallizes protects their investment.
Without the ability to contractually defer payment
until future events are more certain, many deals
would not be consummated. Yet for financial and tax
reporting purposes, the contractual right to future
consideration often presents a dilemma that is less
savory. Accounting questions surrounding contingent
consideration are mired in historical bias and may lead
25

28. Viewing contractual rights as a
contingency and not reporting fair value is inconsistent
with investment company accounting principles.
to a philosophical paradox such as that presented by
Schrödinger’s cat or Morton’s Fork.
Contingent Consideration—Missing
the Forest Because of the Trees
Morton’s Fork is a logical dilemma in which people
are faced with a decision whereby no matter which
approach they choose, there are distasteful results for
both options. You could think of it as being “between
the devil and the deep blue sea,” as the saying goes.
Unless the victim of the dilemma manages to find
an exception, the outcome of the situation will most
probably be undesirable. Morton’s Fork got its name
from Lord Chancellor John Morton, who worked in
England under Henry VII. According to Morton’s logic,
wealthy subjects of the Crown obviously had money
to be spared for taxes, and poor subjects were clearly
sitting on savings, so they could also bear high taxes.
Rich and poor alike found themselves at the points of
“Morton’s Fork,” paying high taxes. Clearly this logic
could be applied to the debate on the taxation of carried
interest, but that’s a discussion for another article.
Deal professionals are well versed in structuring
contracts to take into account various outcomes. Often
these contractual rights are termed “contingencies.”
Historically, when accountants heard the word
“contingency” they immediately thought of FASB
Statement 5 (now known as ASC Topic 450). FASB
Statement 5 became effective in 1975, at a time
when all accountants were well schooled in the
principles of conservatism. Statement 5 did not allow
“gain contingencies” 1 to be recorded in the financial
statements.
Because of this historically indoctrinated conservative
bias, many accountants believe that it is inappropriate
to record in the financial statements the value
of contingent consideration. Some have used a
discussion by the Emerging Issues Task Force
that was considering the question of contingent
consideration by the seller in a business combination,
but that was unrelated to venture capital or investment
company accounting (ASC 946), as support for not
reporting the fair value of future consideration.2 Yet,
the application of FASB Statement 5 and the EITF
non-decision is misguided. In the context of a venture
capital exit that includes potential future consideration,
the right to the future consideration is contractual.
Said differently, a contractual right exists. The right
itself is not contingent; the future consideration is
variable depending on future events and outcomes.
In many ways this is no different than the ownership
in an underlying portfolio company; an ownership
right exists; the future cash flows that will result from
that ownership right are dependent (contingent) upon
future events. The same concept applies to warrants
or options. The ultimate value is contingent upon
When faced with Morton’s Fork, the temptation
may be to do nothing, but sometimes this is also a
bad alternative. A more thoughtful consideration of
the options either reveals an additional choice, or a
choice in the array of existing options which is less
repugnant. It may also be possible to subvert Morton’s
Fork by finding or creating an exception to the rule.
Being between a rock and a hard place is sometimes
solvable if one is willing to develop a hammer to smash
the rock out of the way. Morton’s Fork, in the context
of “contingent consideration,” is the somewhat equally
unpleasant situation of a historical practice of not
reporting the fair value of such arrangements and the
new paradigm of LPs, who use net asset value (NAV)
to estimate the fair value of an interest in a venture
capital fund, being required to have all underlying
investments reported by the manager at fair value.
The hammer in this situation may indeed be a
thoughtful approach to estimating the fair value
of contingent consideration in situations where it
is warranted.
1 FASB Statement 5, Paragraph 17—Contingencies that might result in gains
usually are not reflected in the accounts since to do so might be to recognize
revenue prior to its realization.
2 EITF 09-4—The EITF did not reach a consensus decision on the sellers
accounting for contingent consideration in a business combination.
26

29. Contractual Rights: a Modern-Day
Morton’s Fork
future events. To avoid confusion and misapplication
of Generally Accepted Accounting Principles, it is more
appropriate to describe “contingent consideration” in
its legal form, that being a “contractual right” to future
consideration.
As noted above, historical practice, training and
bias drive many accountants to find the notion of
estimating the fair value of future, unknown, cash flows
associated with a contractual right to be distasteful.
Some believe estimating the fair value of contractual
rights is not possible, while others believe that such
estimations are not cost beneficial. However, uniformly,
when VC managers are asked if they will sell their
“contractual rights” for $100, they respond “absolutely
not, they have much greater value than that.”
Therefore, it should be clear that contractual rights
do have value. The difficulty then is estimating the
fair value of contractual rights on a consistent, costeffective, basis.
Now we move to 2006 when FASB issued Statement
157 (now known as ASC Topic 820) Fair Value
Measurements. While Statement 157 did not require
any asset or liability to be reported at fair value
(Under US Generally Accepted Accounting Principles,
investment companies have been required to use
fair value since at least 1940), it did re-highlight
issues surrounding the application of fair value
principles. Further, in 2009, FASB clarified that limited
partners are allowed to use reported NAV in certain
circumstances to estimate the fair value of a limited
partnership interest. Those circumstances include that
the underlying assets from which NAV is comprised
are reported at fair value and are in-phase (as of the
same measurement date).
US GAAP requires corporations who purchase a
company in a purchase business combination to
record as a liability the fair value of earn-outs or other
future payments dependent upon future events. The
fair value of such liabilities are adjusted at future
measurement dates. If the fair value of the liability side
of a contractual right arrangement can be estimated,
it should be clear that the fair value of the asset side
of a contractual right arrangement can also be
estimated. Depending on the size and complexity of
the agreement, the tax impacts and future variability,
some managers use the services of a third-party
valuation expert to assist in determining fair value.
However, generally, such fair value estimates can be
made by the manager themselves.
All of this history and background has resulted in a
clash of paradigms:
Old Paradigm
New Paradigm
Conservatism is good!
Conservatism means
purposefully understating
Contingent gains are not
recorded
All assets are reported at
fair value
LPs could blindly accept
reported NAV
LPs must satisfy
themselves that NAV
is derived from the fair
value of all underlying
investments.
Practical Solutions to Valuing
Contractual Rights
Our experience working with investment managers
shows that many managers are reluctant to estimate
the fair value of future payments contingent upon
future events, because they are concerned that such
estimates potentially open a Pandora’s Box that would
expose them to more audit/regulatory scrutiny and
volatility of returns. However, as stated above, viewing
these types of arrangements as a contingency and
not reporting any value until payment is received is not
consistent with either investment company accounting
rules or fair value accounting principles. Investment
company accounting guidance requires all contractual
rights be recognized in a fund’s financial statements at
fair value. More importantly, LPs are not allowed to use
LPs generally ignored the If a contractual right is
fair value of contractual
not recorded at fair value
rights, if any
the LP either cannot use
NAV as their FV estimate
or must adjust reported
NAV to include the FV
of contractual rights, if
significant.
All investment company assets, including investments in
debt, equity, options, warrants and contractual rights are
required by GAAP (FASB ASC Topic 946) to be reported
at fair value. However, practice continues to vary.
27

30. LPs are not allowed to use NAV to estimate the
fair value of their fund interest if all underlying assets are
not reported at fair value.
• mportance of the contingent payment(s) to
I
the deal, fund IRR calculations or the potential
value in relation to the original investment
NAV to estimate the fair value of a fund interest if all
underlying assets are not reported at fair value.
Since of the components of contractual rights can
vary significantly in form and complexity, the level of
effort (or cost) to estimate fair value will also vary. It is
not practical to value every contractual right using the
same process or model. Venture Capital investment
managers must use a pragmatic approach valuing
contractual rights by selecting a policy which is
dependent upon the nature of the contractual right.
Just like the valuation of other venture investments
requires judgment, the estimation of the fair value of a
contractual right requires judgment.
• omplexity of the terms affecting the visibility
C
of likely outcomes
• ength of time expected for the contingency
L
to resolve itself
• he nature of the contingency; certainty of
T
payment or performance
• ange of potential outcomes (variance of
R
payments)
• nformation usefulness for an investor; would
I
investors find the results of the analysis useful
in making decisions about their investment or
exposure to the asset class or sector in making
transaction, future investment decisions (return/
track record) or asset allocation decisions or in
assessing the usability of NAV as the investors’
fair value estimate?
Ultimately the decision of what qualifies as appropriate
procedures for estimating the fair value of each
contractual right will come down to discussions with
an investment manager’s auditors, valuation provider,
and/or investors. These discussions should be
centered on the following factors that may help frame
overall policy and procedures:
28

31. be estimated by applying an appropriate discount
rate. In determining the right discount rate to use,
the following risks factors should be considered: 1.
Risk associated with the related outcome (assumed
payment level of the contingency) and the assumptions
used to determine that outcome (i.e., business risk as
estimated by the company’s WACC or deal implied
IRR), 2. How the probabilities or the weighting of
various scenarios affects the overall risk of payment,
3. The counterparty risk associated with the acquirer,
and 4. The degree of confidence surrounding the
probability-weighted estimated cash flows. While this
process sounds complex, it can be accomplished in
most cases with limited additional effort because deal
professionals have assessed the probability of future
cash flows in negotiating the terms of the contractual
right.
So how do you value a contingent payment,
contractual right?
Due to the unique aspects of these types of rights,
it is likely that an income approach (discounted cash
flow) will be the best tool to estimate fair value. This
requires the development of expected cash flows
and an appropriately chosen discount rate. Estimated
cash flows in their simplest form are determined by
assessing the probability of payment at various points
in time.
Cash flow assumptions should include the
estimation of the likelihood and timing of various
possible outcomes for achievement of the specified
contingency and/or consider scenario-based
projections relevant to the specified contingencies.
The key starting point is to decompose the factors that
would lead to a contingency being met (or not being
met). The manager must identify sources of data to
be used to support assumptions. It is possible to keep
the analysis relatively simple while still incorporating the
material complexities of the contractual right.
Monitoring
Care should be taken in selecting a model that relies
on supportable and easily understood assumptions/
probabilities/scenarios since the fair value of a
contractual right will need to be updated regularly.
These assets will need to be revalued each reporting
period until the contingency is resolved. If a model is
not robust enough to handle changing company and
market conditions, and if the inputs to the model are
not easily supported or are difficult to estimate, the
measurement and reporting of contractual rights may
become difficult and a source of debate between
interested parties. However, with careful consideration
of the probability-weighted cash flows and discount
rate, the reporting of the fair value of contractual rights
can be meaningful for the investment manager as well
as the investors in the fund.
Typically, contingent payments are structured based
on reaching a particular technical or functional
milestone, or on revenue, gross profit or EBITDA
targets. For milestone contingencies the likely value will
be a function of the likelihood of meeting the milestone
requirements and the associated payment.
For nonlinear targets like revenue or various profit
targets, a natural starting point is to consider the
company’s forecasted financial metrics and compare
them to the contingent target(s), while considering
various potential scenarios that would lead to a
meaningful range of outcomes (full payment, partial
payment(s), and no payment of the contingency).
Since the payoff of contingent consideration based on
financial performance is typically nonlinear, in order
to calculate the expected cash flow arising from the
contractual right, it is appropriate to consider the
payment associated with each point on a distribution
of possible outcomes, which can be estimated by
probability-weighting meaningful scenarios or by
employing other valuation techniques such as option
pricing models (binomial) and simulations (Monte
Carlo), which can be particularly helpful when dealing
with more complex contingent payment structures.
It should also be noted that in many cases, the fair
value of a contractual right will be relatively small at
inception. As time passes, the visibility and confidence
in future cash flows, if any, will increase. Generally
this means that the discount rate will decrease as the
clarity of estimated future cash flows improves.
Conclusion
Because of regulation, transparency, globalization,
economic conditions and investor needs, the venture
capital industry finds itself today firmly in a fair value
reporting regime. LPs find themselves under increasing
scrutiny as they attempt to report performance on
Given an estimate of the cash flow associated
with a contractual right, the present value must
29

32. Contractual rights
are difficult to value, but
arguably no more difficult
to value than an option,
warrant, or any early
stage enterprise.
• US GAAP requires investment companies to
report all assets at fair value.
• So-called “contingent consideration” is a legal
contractual right to future cash flows depending
upon future events.
• contractual right is not contingent; the cash
A
flows it describes may be subject to future events,
but the right itself is not contingent.
• Ps need their GP to provide fair-value-derived
L
NAV based on the fair value of all assets including
contractual rights.
a consistent basis across all the asset classes in
• ontractual rights are difficult to value, but
C
arguably no more difficult to value than an option,
warrant or any early stage enterprise.
which they invest. The purpose of this article is not to
describe all factors associated with estimating the fair
value of contractual rights. The paradox of Morton’s
Fork seems to indicate that neither the GP nor the LP
Estimating the fair value of all assets, including
contractual rights, while imperfect and subject to
judgment, continues to be the best basis for reporting
the value of investments on a periodic basis. 
really want to be full fair value reporters. However, if
the paradigm is shifted, and after smashing the fair
value boulders that seem to be insurmountable, the
following key points remain:
About the Authors
David L. Larsen is a Member of FASB’s Valuation Resource Group, a Board Member of the International Private Equity and
Venture Capital Valuations Board (IPEV), leads the team that drafted the US PEIGG Valuation Guidelines, and is a Member of
the AICPA Net Asset Value (NAV) Task Force. Mr. Larsen serves a wide variety of alternative asset investors and managers in
resolving valuation and governance related issues.
Steven Nebb serves as the project lead for numerous Alternative Asset managers and investors including large global private
equity, venture capital and Business Development Companies. He provides advisory support to many limited partnerships
and corporate pension plans regarding fund management, financial reporting requirements and general valuation of
investments, and has over 14 years of experience in performing valuations of intellectual property, private equity, illiquid debt
and complex derivatives for a variety of purposes including fairness opinions and transaction advisory, financial reporting, tax,
litigation, and strategic planning.
30