Know Your Valuation for Equity Compensation (And Avoid the Perils of 409A)


Published on

October 3, 2013
12:00pm – 2:00pm
Bessemer Venture Partners, 196 Broadway, 2nd Floor
Cambridge, MA 02139

If you are a CEO or a CFO of a high growth startup, it is vital to understand how to value your company correctly.

Here is a quick list of questions this lunch will help you answer:

Do you offer or are you planning to offer your employees stock options? Do you know the difference between ISOs and non-ISOs? Do you understand the general valuation concepts and approaches that the IRS has outlined, especially as they apply to early-stage companies? Did you know that if you run afoul of the 409A rules, your employees could have an unpleasant tax surprise and that some of that responsibility could revert back to you as the employer? Do you know if and when you need to engage an outside expert to assist with a valuation?

This is a limited seat lunch to teach issues of valuation for equity compensation and ask specific questions about your company.

Experts -

Scott Goodwin, Wolf & Company, P.C.

Alicia Amaral, Scalar Analytics

Published in: Business, Technology
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Know Your Valuation for Equity Compensation (And Avoid the Perils of 409A)

  1. 1. MEMBER OF PKF NORTH AMERICA, AN ASSOCIATION OF LEGALLY INDEPENDENT FIRMS © 2010 Wolf & Company, P.C. Understanding  Equity  Valua2on   and  Avoiding  the  Perils  of  409A     October  3,  2013   Exclusively  for    
  2. 2. 2 Introduc2ons   •  ScoG  Goodwin  –  Wolf  &  Company,  PC   –  Member  of  the  Firm   –  Technology  Services  Team  Leader   –  TCN  board  of  directors  and  program  commiGee  chair   •  Alicia  Amaral  –  Scalar  Analy2cs   –  Managing  Director   –  Visi2ng  Professor,  Clark  University  and  TuWs  University   –  CPA  and  CVA   –  Past  CFO  
  3. 3. 3 Who  is  Wolf  &  Company?   •  Boston  based,  regionally  focused   •  19  owners  and  190  professionals  in  three  offices   •  Niche  focused   –  Technology  Services  Team   •  Provide  our  clients  with  direct  access  to  owner-­‐level   exper2se   •  Ability  to  grow  with  you  
  4. 4. 4 Who  is  Scalar  Analy2cs?   •  600+  valua2ons  per  year  (50%  are  409A)   •  Majority  of  clients  backed  by  venture  capital  firms   and  angel  groups   •  Clients  in  virtually  every  industry   •  Work  with  all  of  the  “big  4”  audit  firms  and   countless  regional  firms  
  5. 5. 5 Agenda   •  Overview  of  stock  compensa2on  plans   •  Overview  of  IRC  Sec2on  409A   •  The  who,  what,  why  and  how  of  valua2ons   •  Q&A  
  6. 6. 6 Stock  Compensa2on     Overview   •  Common  forms  of  stock  compensa2on   –  Founders  shares   •  Not  really  compensatory   •  Beware  of  retroac2ve  ves2ng  provisions   •  How  long  can  you  issue  them?   •  Other  issues   –  Founders  coming  and  going  
  7. 7. 7 Stock  Compensa2on     Overview   •  Common  forms  of  stock  compensa2on   –  Op2on   •  ISOs  –  tax  treatment   –  No  tax  at  issuance   –  No  tax  upon  ves2ng   –  No  tax  upon  exercise   –  Only  taxable  upon  sale  of  underlying  stock   –  Ability  to  get  LT  cap  gain  tax   •  ISO  criteria   –  8  criteria  for  being  considered  an  ISO   –  Three  of  the  more  important  ones   »  Issued  under  a  formal  wriGen  plan   »  Exercise  price  >=  FMV  of  stock   »  Can’t  be  issued  to  non-­‐employee  
  8. 8. 8 Stock  Compensa2on     Overview   •  Common  forms  of  stock  compensa2on   –  Op2ons   •  Non-­‐quals  -­‐  tax  treatment   –  No  tax  at  issuance   –  Taxable  income  equal  to  the  difference  between  FMV  of  the  stock  and  the  exercise   price   –  Ordinary  income   »  Possible  addi2onal  tax  when  stock  sold   •  Factors  to  consider  when  issuing  op2ons   –  Tax  advantages   –  Less  immediate  dilu2on   –  Keep  stock  in  few  hands  for  longer   –  Difficult  to  value  and  account  for  
  9. 9. 9 Stock  Compensa2on     Overview   •  Common  forms  of  stock  compensa2on   –  Restricted  stock   •  Generally  common  stock  with  ves2ng  or  repurchase  rights   •  General  tax  treatment   –  Taxed  as  the  shares  vest   –  Income  based  on  FV  of  shares  on  the  date  of  ves2ng   –  Ordinary  income   •  Factors  to  consider   –  Can  be  tax  advantages   »  83(b)  elec2ons   »  Start  LT  cap  gain  clock  2cking   –  FV  is  easier  to  establish  for  a  share  of  stock  than  an  op2on   –  BeGer  understood  by  recipients   –  True  dilu2on   –  End  up  with  more  shareholders   »  Considera2on  when  you  want  to  pay  vendors  with  shares.    Do  you  want  them  as   shareholders?  
  10. 10. 10 Overview  of  IRC     Sec2on  409A   •  What  is  it?   –  Part  of  the  IRC  –  issued  by  the  IRS   •  No  impact  on  accoun2ng  rules   –  Very  comprehensive  and  far  reaching  impact/scope   –  Regula2on  governing  a  wide  array  of  non-­‐qualified  deferred   compensa2on  arrangement,  including  op2ons   •  “Deferred  compensa2on”  –  legally  binding  right  to  receive  compensa2on  in   one  tax  year  that  is  or  may  be  taxable  in  a  subsequent  tax  year   –  Reac2on  to  perceived  abuses  from  some  earlier  scandals   including  the  op2on  back-­‐da2ng  scandal  
  11. 11. 11 Overview  of  IRC     Sec2on  409A   •  How  does  it  impact  stock  compensa2on?   –  Can  no  longer  safely  issue  op2ons  using  a  rule-­‐of-­‐thumb  or  simple   board  approval   –  In-­‐the-­‐money  op2ons  are  imprac2cal   –  409A  is  forcing  companies  to  get  outside  valua2ons  of  their  stock   in  order  to  appropriately  set  exercise  prices   –  409A  is  forcing  companies  to  be  more  disciplined  in  their  gran2ng   process  
  12. 12. 12 Overview  of  IRC     Sec2on  409A   •  What  is  the  worst  that  could  happen?   –  An  op2on  issuance  intended  as  an  EE  benefit  could  cause  tax   problems  for  the  recipient   –  Lose  the  tax  benefits  of  ISOs   –  EE’s  perspec2ve   •  Ordinary  income  in  the  periods  in  which  op2ons  VEST  rather  than  when  they   are  exercised   •  Regular  tax  rates  (rather  than  cap  gains)   •  20%  penalty   •  Possible  interest  and  penal2es  for  late  payment  or  underpayment   –  ER’s  perspec2ve   •  Very  unhappy  employees!   •  Withholding  obliga2on   •  ER  por2on  of  employment  taxes   •  Possible  responsibility  for  EE’s  por2on  of  withholdings   •  Possible  legal  liability  if  sued  by  EE  
  13. 13. 13 Overview  of  IRC     Sec2on  409A   •  What  do  you  as  an  entrepreneur  need  to  know  to   stay  out  of  trouble?   –  With  respect  to  op2ons   •  ISOs   –  These  have  always  been  required  to  be  recorded  at  FV  so  409A  really  didn’t   change  anything   –  But  did  provide  some  guidelines  that  should  be  followed  related  to  valua2on   •  Non-­‐quals   –  Will  need  to  deal  specifically  with  409A   –  General  409A  compliance  requirements   •  Exercise  price  >=  FMV  of  underlying  common  stock  at  grant  date   •  FMV  must  be  determined  by  the  “reasonable  applica2on  of  a  reasonable   valua2on  methodology”  
  14. 14. 14 Overview  of  IRC     Sec2on  409A   •  What  do  you  as  an  entrepreneur  need  to  know  to   stay  out  of  trouble?   –  General  409A  compliance  requirements   •  “Reasonable  valua2on  methodology”  must  include  considera2on  of:   –  Tangible  and  intangible  assets   –  PV  of  future  cash  flows   –  MV  of  the  stock  of  similar  companies   –  Recent  transac2ons   –  Appropriate  premiums  and  discounts   •  Must  be  within  12  months  of  when  valua2on  is  being  used   –  Or  more  frequently  based  on  a  “significant  events”  in  the  business   –  Safe  Harbor  Valua2on  Methods   •  Safe  harbors  are  not  a  “silver  bullet”   –  ShiWs  the  burden  of  proof  from  you  to  the  IRS  related  to  valua2on   –  May  only  be  rebuGed  by  the  Internal  Revenue  Service  if  the  company's  applica2on   of  the  method  is  found  to  be  "grossly  unreasonable."    
  15. 15. 15 Overview  of  IRC     Sec2on  409A   •  What  do  you  as  an  entrepreneur  need  to  know  to   stay  out  of  trouble?   –  Safe  Harbor  Valua2on  Methods   •  Independent  appraisal   –  Using  the  standard  valua2on  methodologies   •  Illiquid  start-­‐up   –  Uses  valua2on  factors  outlined  in  General  Rule   –  WriGen  report   –  Company  less  than  10  years  old   –  Valua2on  performed  by  someone  with  significant  experience,  educa2on  and   training  in  this  area  (>=  5  years)   »  CFO   »  CEO   »  Investment  banker   –  Reasonable  expecta2on  that  no  change  in  control  within  90  days  or  IPO  within  180   day  
  16. 16. 16 Overview  of  IRC     Sec2on  409A   •  What  do  you  as  an  entrepreneur  need  to  know  to   stay  out  of  trouble?   –  Safe  Harbor  Valua2on  Methods   •  Binding  formula   –  Use  formula  based  on  book  value,  mul2ple  of  earnings  or  combina2on   –  Stock  transfers  must  be  restricted   –  All  transac2ons  must  use  the  same  binding  formula  
  17. 17. 17 Overview  of  IRC     Sec2on  409A   •  What  are  best  prac2ces  at  various  stages  of   development?   –  Founding  stage   •  Founders  stock  and  restricted  stock  more  frequently  than  op2ons   •  Using  general  valua2on  factors  is  imprac2cal  due  to  limited  amount  of   informa2on,  opera2ng  history,  etc.  
  18. 18. 18 Overview  of  IRC     Sec2on  409A   •  What  are  best  prac2ces  at  various  stages  of   development?   –  Start-­‐up   •  Friends  and  family  or  some  angel  financing   •  Op2on  issuances  start   –  Companies  are  looking  at  the  cost/benefit  of  gewng  a  valua2on   –  Depends  on  your  and  the  BODs  risk  tolerance   •  If  using  Illiquid  Start-­‐up  safe  harbor   –  Document  qualifica2on  of  person  performing  the  calc   –  Consult  outside  resources   –  Get  BOD  approval  and  document   –  For  as  long  as  you’re  using  the  value,  consider  impact  of  events  that  may  have   changed  the  value   •  Be  aware  of  possibility  of  changes  in  control  in  the  near  term  
  19. 19. 19 Overview  of  IRC     Sec2on  409A   •  What  are  best  prac2ces  at  various  stages  of   development?   –  Post-­‐start  up   •  Venture  financing,  decent  amount  of  revenue   •  Almost  all  companies  are  op2ng  for  a  formal  outside  valua2on   •  Updated  annually   –  Possibly  mid-­‐year  depending  on  what  developments  take  place  during  the  year   •  More  likely  to  have  changes  in  control  at  this  stage   –  Other  things  to  keep  in  mind   •  There  has  not  been  any  case  law  in  this  area  yet  so  how  409A  will  be  applied   to  op2ons  in  prac2ce  is  s2ll  unclear   •  Modifica2ons  to  op2ons  can  trigger  new  409A  considera2on   •  In  acquisi2on  situa2on,  don’t  be  surprised  to  be  asked  for  documenta2on  of   compliance  with  409A  
  20. 20. Standard  of  Value   •  Fair  Market  Value   –  Assumes  hypothe2cal  buyer   –  This  is  standard  for  409A  (per  IRS)   •  Investment  Value   –  Assumes  strategic  buyer   409A  ≠  VC  investment   20
  21. 21. Standard  of  Value   •  Fair  Market  Value   •  Rev.  Rule  59-­‐60  “The  price  at  which  the  property  would   change  hands  between  a  willing  buyer  and  a  willing  seller,   neither  being  under  any  compulsion  to  buy  or  sell,  and   both  having  reasonable  knowledge  of  relevant  facts.”   •  Important  because  this  does  not  assume  a  strategic  buyer.   This  is  the  standard  for  409A.   21
  22. 22. Standard  of  Value   •  Investment  Value   •  “The  value  to  a  par2cular  investor  based  on  individual   investment  requirements  and  expecta2ons”.   •  Value  is  different  depending  on  synergies.   •  Applies  to  specific  buyer  rather  than  hypothe2cal  buyer.     •  Investment  value  is  usually  higher  than  fair  market  value   because  of  synergies,  and  specific  buyer  is  inves2ng  for   poten2al  return  in  the  future.     22
  23. 23. Three  Valua2on  Methods   1. Asset  Approach   2. Market  Approach   3. Income  Approach   23
  24. 24. 1.  Asset  Approach   •  Applicable  only  for  companies  in  early  stage   (difficult  to  defend,  last  resort  if  there  are  no   other  data  points)   •  The  Asset  Approach  establishes  value  based   on  the  cost  of  reproducing  or  replacing  the   property,  less  deprecia2on.     •  Applied  to  specific  assets,  such  as  land   improvements,  special-­‐purpose  buildings,   special  structures,  systems,  special  machinery   and  equipment,  and  certain  intangible  assets.    
  25. 25. 2.  Market  Approach   •  Based  on  the  assump2on  that  the  value  of  an   asset  (including  a  company)  is  equal  to  the   value  of  a  subs2tute  asset  with  the  same   characteris2cs.   •  Infer  value  by  finding  similar  assets  that  have   been  sold  in  recent  transac2ons.   •  Similar  to  real  estate  transac2ons.  
  26. 26. 2.  Market  Approach   a)  Recent  securi?es  transac?on  method.  Based  on   recent  transac2ons  of  company’s  securi2es  Ex:   preferred  stock  sold  to  angels.  Backsolve  method   uses  OPM  based  on  preferred  rights.   b)  Comparable  public  co.  Uses  revenue  and  EBITDA   mul2ples  from  companies  in  same  industry.   c)  Comparable  transac?on  method.  Similar  to  b)  but   uses  private  company  transac2ons  from  databases   such  as  CapIQ  and  Bloomberg.   d)  Industry  specific  mul2ples  (N/A).  Ex:  headcount,   backlog,  revenue  per  employee,  #  of  customers,  #  of   users.  
  27. 27. 3.  Income  Approach   •  Discounted  Cash  Flows  (DCF).   •  Present  value  of  future  cash  flows.   •  Discount  rate  is  based  on  rela2ve  riskiness  of   investment.   •  Use  this  method  if  can  reasonably  rely  on   projec2ons.  
  28. 28. 2b.  Market  Example:  Guideline     Public  Company  Method   Data  for  similar  public  companies  in  same  industry.  For  our   example  company,  Venture  Co,  these  are  comparable  public   companies:   •,  Inc.   •  Concur  Technologies,  Inc.   •  Kenexa  Corp.   •  LogMeIn,  Inc.   •  Constant  Contact,  Inc.   For  example,  Salesforce  has  a  market  cap  of  $31B  which  is  the  “value”  of  the   company  (market  cap  is  the  stock  price  *  number  of  share  outstanding).   Salesforce  has  revenues  of  $6.2B.  Therefore,  the  mul2ple  is  $31B  /  6.2B  =  5   Analyst  takes  average  mul2ples  of  all  applicable  companies.   28
  29. 29. 2b.  Market  Example:  Guideline     Public  Company  Method   29 •  This  chart  for  Venture  Co.  applies  the  average  mul2ples  to   the  revenue  and  EBITDA  to  calculate  vaue.   •  Since  EBITDA  is  nega2ve,  it  is  not  considered.  
  30. 30. Steps  in  the  Valua2on  Process   1.  Take  weighted  average  of  applicable  methods   (asset,  market  or  income)  to  come  up  with   enterprise  value   2.  Allocate  the  enterprise  value  among  classes  of  stock   Remember  that  the  purpose  of  409A   is  to  value  common  stock   30
  31. 31. Valuation 7 Step 1 – Determine enterprise value using weighted average of applicable methods (Asset, Market and Income)
  32. 32. Step  2:  Alloca2on   •  Simply  means  “who  gets  what”  in  the  event  of  an  exit   •  Common  shareholders  get  paid  aWer  preferred   32
  33. 33. Alloca2on  Methods   •  Current  Value  Method  (“CVM”)  –  assumes   value  today  is  same  as  exit  value   –  Appropriate  only  if  liquidity  value  is  known  as  in  a  pending  deal   •  Probability  Weighted  Expected  Return   (“PWERM”)  –  weighted  average  of  various   scenarios  based  on  probability  (IPO,  sale,   bankruptcy)     –  Probability  based  on  appraiser’s  judgment   •  Op2on  Pricing  Method  (“OPM”)  –  same  logic   as  PWERM  but  considers  more  scenarios   –  Probability  based  on  Black  Scholes  
  34. 34. Op2on  Pricing  Method  “OPM”   •  In  the  event  of  an  exit,  preferred  gets  paid  first   •  Common  only  gets  if  there’s  anything  leW  over   •  Vola2lity  and  2me  to  liquidity  are  important   factors  in  determining  range  of  outcomes   •  Greater  vola2lity  is  beGer  for  common  (lower   lows  but  who  cares  because  below  zero  is   same  as  zero)   •  Longer  life  is  beGer  because  more  opportunity   to  grow  
  35. 35. OPM   •  See  Exhibit  on  following  slide.   •  Common  stock  only  has  value  only  if  funds   available  exceed  liquida2on  preferences  of   preferred.   •  The  OPM  takes  the  weighted  average  of   various  exit  scenarios  (IPO,  M&A,  liquida2on)   and  calculates  the  alloca2on  among  the   classes  of  stock.  
  36. 36. 36
  37. 37. Summary   •  STEP  1    Enterprise  Value      $48,153,573    Less  Debt          (1,750,000)    Equity  Value        $46,403,573   •  STEP  2    Alloca2on  to  common    $15,051,167    Divided  by  #  shares      ÷  20,000    Price  per  share      =  $0.753   37
  38. 38. Discount   •  Private  company  stock  cannot  be  sold  on  the  public  stock   markets.  Analyst  applies  a  discount  to  reflect  this  liquidity   issue.   •  Discount  for  lack  of  marketability  (DLOM)     25  –  45%   •  Discount  for  Venture  Co.  =  35.7%   •  Price  per  share  $0.753  less  35.7%  =     $0.484  per  share   38
  39. 39. Other  Points   •  Value  is  based  on  a  number  of  assump2ons  that  have  a   material  impact  on  the  result:   –  Projected  cash  flows   –  WACC   –  DLOM   –  Comparable  companies   •  Important  to  have  a  “DEFENDABLE  VALUE”  (IRS  and   auditors).   •  Important  to  review  report  for  reasonableness  of   assump2ons.  You  know  your  business.   39
  40. 40. 40 QUESTIONS  AND  ANSWERS  
  41. 41. 41 Thank  You!   ScoG  Goodwin,  CPA   (617)  428-­‐5407   Alicia  Amaral   (617)  684-­‐5510  
  42. 42. 42 Resources   Internal  Revenue  Bulle?n:    2007-­‐19,  Applica?on  of  Sec?on   409A  to  Nonqualified  Deferred  Compensa?on  Plans  -­‐   hRp://­‐19_IRB/ar07.html   IRS  Revenue  Ruling  59-­‐60  -­‐   hRp://   AICPA  Valua?on  of  Privately-­‐Held  Company  Equity   Securi?es  Issued  as  Compensa?on  -­‐      hRp://  
  43. 43. 43 Resources   To  be  posted  to  TCN  website:   •  Detailed  outline  and  PowerPoint  presenta?on   •  Scalar  Analy?cs  –    white  paper,  “Sec?on  409A  –  Common   Stock  Valua?on”