1 business valuation resources teleconference may 2 nd, 2007 – 409a compliance – issues,...

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Business Valuation Resources Teleconference May 2nd, 2007 – 409A Compliance – Issues, Approaches and Mistakes Not

to Make

409A Compliance – 409A Compliance – Issues, Approaches Issues, Approaches and Mistakes Not to and Mistakes Not to MakeMake

A Teleconference from Business Valuation Resources

1-888-BUS-VALU (287-8258)

www.bvresources.com

[email protected]

May 2, 2007

Moderator: Bob Duffy, CPA/ABV, CFA, ASA of Grant Thornton LLP

Panelists: Scott Beauchene, CFA, ASA of Grant Thornton LLP

Joel Johnson, ASA of Orchard Partners, Inc.

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Ancillary Reading Materials• 409A Compliance – Issues, Approaches and Mistakes Not to Make PDF and

PowerPoint Presentation

• The final 409A regulations:

http://www.ustreas.gov/press/releases/hp345.htm

• Getting Ready for 409A: Some Practical Considerations article by Scott

Beauchene and Robert Duffy, published in the May 2007 Business Valuation

Update

• Be Careful When Pricing Employee Stock Options article by Joel Johnson,

published in the February 2006 issue of M & A Today

• A Method for Valuing High-Risk, Long-Term Investments: The "Venture

Capital Method“ by William Sahlman and Daniel Scherlis:

http://custom.hbsp.com/b01/en/implicit/viewFileNavBeanImplicit.jhtml?_requestid=46073

• All downloads available at the BVR Teleconference ancillary reading

materials page: http://www.bvresources.com/defaulttextonly.asp?

f=tcreading050207

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Learning Objectives• Understand the need for and requirements of 409A valuation

engagements

• Compare and contrast Fair Market Value and Fair Value

• Understand the relationship between 409A and 123R and the

significance of the AICPA Practice Aid

• Discuss applicability and magnitude of lack of control and lack of

marketability discounts

• Learn practical tips and methods for interacting with an auditor

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Submitting Questions• Email [email protected] at any time during the

Teleconference

• The final 20-30 minutes is dedicated to telephone questions; the

conference operator will announce Q&A time and provide

instructions on how to join the queue

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What is 409A?What is 409A?

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What is 409A?• In October 2004, as part of the American Jobs Creation Act of

2004, the IRS issued Code Sec. 409A, assessing penalties if

option strike prices not at least at fair market value of the

common stock

• Requires that the valuation of the common stock be based on a

“reasonable application of a reasonable valuation method”

• “Presumption of reasonableness” in 3 instances: 1) valuation by

independent appraiser, 2) FMV formula applied in transactions,

or 3) written report for illiquid stock of a start-up corporation

• If the appraisal is performed by an independent “qualified

individual”, then the value is presumptively fair market value

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What is 409A? [continued]• A safe harbor provision states that, in certain circumstances, a

valuation is assumed to reflect FMV unless it can be shown that

the valuation is grossly unreasonable

• One of these provisions, the “illiquid start-up presumption”, has

been shortened to 90 days for change of control transactions and

180 days for an IPO

• This means that if, at the time the valuation is performed, the

Company does not “reasonably anticipate” a change of control

within 90 days or an IPO within 180 days of the valuation date,

the illiquid start-up presumption applies

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What are the What are the Characteristics of a Characteristics of a Typical 409A Client?Typical 409A Client?

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What are the Characteristics of a Typical 409A Client?• The company is issuing options

• A liquidity event is expected within five years

• The company may be venture backed, and its complex capital

structure with multiple classes of preferred stock may preclude

simplistic approaches to valuation

• Board of Directors of Subject Company requires assistance of

independent valuation specialist in setting option strike price

• Client may need the valuation for IRS purposes only, but most

often the valuation is used for income tax and financial reporting

compliance

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Who is the Audience for a Who is the Audience for a 409A Appraisal?409A Appraisal?

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Who is the Audience for a 409A Appraisal?

• The IRS: Comfortable with discounts, aware of tax court decisions

• The SEC: Uncomfortable with discounts, oriented toward the rules

for financial reporting

• The company’s auditor: Needs a report that can be audited

• The board of directors: Understands value, but unlikely to

appreciate valuation techniques

• Management: Varying levels of sophistication

• The recipient: Wants a low value, but is the potential victim if

value is below FMV

• Potential acquirers: Looking for a liability

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What Guidance and What Guidance and Regulations Apply to a Regulations Apply to a 409A Appraisal?409A Appraisal?

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What Guidance and Regulations Apply to a 409A appraisal?

• In April 2007, final regulations on Code Sec 409A were issued (with an

effective date of January 1, 2008)

• Download the final regulations at:

http://www.ustreas.gov/press/releases/hp345.htm

• Before 409A, in the early 2000s, the SEC asked the AICPA to provide

guidance on the allocation of value between preferred and common

shares

• The AICPA responded by publishing a Practice Aid in 2004 named

Valuation of Privately-Held-Company Equity Securities Issued as

Compensation

• Rejects “rules of thumb” and advocates the use of a

“contemporaneous appraisal” by an “unrelated valuation specialist”

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What Guidance and Regulations Apply to a 409A appraisal? [continued]

• There is an assumption that the Practice Aid represents “best

practices,” but the IRS has not indicated whether or not it will

follow the Practice Aid

• In 2005, the FASB issues FAS 123R, requiring the expensing of

stock options issued as compensation to employees

• Under FAS 123R, it is necessary for nonpublic entities to

determine the fair value of their shares

• Thus, the company may have a tax need (under 409A) and a

financial reporting need (under FAS 123R)

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How Does Fair Market How Does Fair Market Value Compare to Fair Value Compare to Fair Value?Value?

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How does Fair Market Value Compare to Fair Value?• Rev Rul. 59-60 defines fair market value as “the price at which

the property would change hands between a willing buyer and a

willing seller, when the former is not under any compulsion to

buy and the latter is not under any compulsion to sell, both

parties having reasonable knowledge of relevant facts”

• FAS 157, Fair Value Measurements defines fair value as “the

price that would be received to sell an asset or paid to transfer a

liability in an orderly transaction between market participants at

the measurement date”

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How does Fair Market Value Compare to Fair Value? [continued]• To date, neither the SEC nor the IRS has stated definitively

whether these two standards of value would result in similar

valuation conclusions

• In May 2003, the FASB stated that “fair value, as refined, is

consistent with the definition of fair market value in IRS Rev Rul.

59-60;” to date, this comment has not been rescinded or

modified

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Certain Differences Do Exist Between Fair Value and Fair Market Value• Fair value follows a specified hierarchy of assumptions and inputs

while fair market value has no stated hierarchy or preference

• Fair value disallows blockage discounts while fair market value

does not

• SEC employees have stated in a private conversation that the SEC

does not possess sufficient knowledge of fair market value to say

whether a similar or disparate conclusion would be reached under

both standards

• IRS employees, in a private conversation, stated the IRS had a

similar lack of knowledge about fair value

• The Practice Aid states that the current method be used only in

certain limited circumstances; the IRS has no such prohibition

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How Difference Applies to Minority Common Stock Valuations• The GAAP-based hierarchy and blockage discount prohibition

should, in most cases, result in little difference between fair value

and fair market value

• The lack of prohibition against the current value method in 409A

guidance could result in significant differences

• The Practice Aid valuation approaches and the “auditor/SEC

audience” indicate smaller discounts should be applied in fair

value assignments

• The IRS, on the other hand, has not provided guidance on

valuation approaches and has historically been more open to

discounts

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How Difference Applies to Minority Common Stock Valuations [continued]• Practical questions exist in that, if in the future the client’s

company requires both an IRS-compliant and a financial

reporting-compliant valuation, how and should you reconcile

between the two standards of value

• Do comments from the auditor and/or SEC affect a conclusion of

value for tax purposes?

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The AICPA Practice AidThe AICPA Practice Aid

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For a Combined 409A/123R Appraisal, Most Auditors Will Expect the Appraiser to Follow the Practice Aid

What the Practice Aid is and is not:

• Not intended to focus on the value of the enterprise as a whole

• Is intended to provide guidance to management, BOD, auditors, and

other interested parties

• Not intended to serve as a detailed “how to” guide

− overview and understanding of the valuation process

− best practice recommendations

• Intended to move past rule of thumb and historical cost based

methods

• Intended to capture future value scenarios

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Two Parts to the Analysis when Complex Capital Structure Exists

• Estimate the enterprise value

• Allocate the value to different equity classes such as preferred

and common stock

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Enterprise Value Methods• Enterprise value can be estimated based on traditional cost,

market, and income approaches

• The latest round of financing can represent a market approach

indication of value of the recently issued preferred

• The pre-money value from the term sheet plus the current round

is not a reliable measure of enterprise value

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Enterprise Allocation Methods• Current-Value Method (CVM)

• Option-Pricing Method (OPM)

• Probability-Weighted Expected Return Method (PWERM)

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Current Value Method• Current Value allocates current value of the enterprise to each

class of security based on its present rights, preferences and

conversion features (i.e., ignores preferred's ability to defer the

conversion decision)

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Current Value Method [continued]Is appropriate in two limited circumstances:

• A liquidity event is imminent that does not force the conversion of

preferred into common

• The enterprise is at such an early stage of development that:

− No material progress has been made on the business plan

− No significant common equity value has been created

− There is no reasonable basis for estimating the amount and

timing of probable future common value

• Benefit of current value method is that it is easy to use and easy

to understand

• Drawback is that it is applicable to only a narrow range of

circumstances

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Option-Pricing Method• Treats common and preferred stock as call options on enterprise

value

• Utilizes Black-Scholes or binomial models to calculate value

• Is useful for valuing securities when there is a high degree of

uncertainty regarding their potential future values

• Is sensitive to estimates of volatility and term/life

• Does not capture the effects of potential future radical spikes in

value as well as probability weighted model

• Benefit of OPM: a relatively objective approach to allocating value

when uncertainty is high

• Drawback of OPM is that it can be difficult to explain and understand

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Probability Weighted Expected Return Method• Rooted in decision-tree analysis

• Models potential future expected outcomes (sale or merger; IPO;

dissolution; or continuation as a going concern)

Encompasses the following steps:

• Estimate future values for each potential outcome

• Allocate future value to each share class

• Discount to present value, by class, these potential future values

• Assign probabilities to each outcome

• Estimate share value by summing the probability-weighted

outcomes

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Probability Weighted Expected Return Method [continued]• Unlike the OPM, this method determines enterprise value and

allocates value at the same time

• Benefit: relatively easy to understand and use

• Drawback: subject to significant judgment

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Selecting an Allocation Method• Does the method reflect the going concern expectations of each

class of security holder?

• Does the method ascribe some value to the common stock if the

company is not in liquidation?

• Can the results be independently replicated or approximated?

• Do the benefits of using the model exceed the cost of

implementation?

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How to Handle the Price How to Handle the Price Paid for Preferred SharesPaid for Preferred Shares

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How Do You Handle the Price Paid for Preferred Shares?• Often the appraisal date is the date of a preferred financing

• How does the price paid for the preferred shares enter into the

valuation analysis?

Enterprise Value: Term Sheet Pre-money:

• Value of the current preferred round multiplied by the existing

outstanding shares (and expanded option pool)

• Using this as an enterprise value presumes that all equity is

equally valuable

• The point of allocating to different equity classes is to capture the

differences

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Not all Preferred Has the Same Terms

Q4 2006 Q3 2006 Q2 2006 Q1 2006

Multiple LP 14% 26% 16% 14%

1-2X LP 40% 90% 83% 80%

2-3X LP 60% 10% 0% 20%

> 3X LP 0% 0% 17% 0%

Participation 73% 64% 71% 65%

Source: Fenwick & West

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Assume 1 Million Shares Outstanding & $2.5 Million Is Raised at $5.00 Per ShareFirst VC

• 1X LP• No participation

Second VC

• 2X LP• Participation

Pre-money value is $5 million in both cases

• 1,000,000 shares x $5 = $5,000,000

• 500,000 shares x $5 = $2,500,000

• $5,000,000 + $2,500,000 = $7,500,000

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Assume Business Is Sold for $10,000,000First VC

• LP is $2,500,000

• Conversion value is $10,000,000 x

33% = $3,333,000

• Proceeds to remaining common

shareholders $10,000,000 -

$3,333,000 = $6,667,000

Second VC

• LP is $5,000,000

• Proceeds after payout of LP $10,000,000 -

$5,000,000 = $5,000,000

• Participation is $5,000,000 x 33% =

$1,667,000

• Proceeds to remaining common

shareholders $5,000,000 - $1,667,000 =

$3,333,000

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How Do You Handle the Price Paid for Preferred Shares? [continued]Enterprise Value: Through Allocation Methods

• We said the Practice Aid intended to capture value scenarios

• From a common stock holder’s perspective, when dividends are

not paid, the future liquidity event reflects the total return

expectation for the investment

• Whether you use the Option Method or Probability Scenario the

future values relate to the enterprise value as of the valuation

date

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Liquidity Allocation ScenariosViewed through Binomial Model

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

11.26 12.96 14.93 17.20 19.82 22.83 26.29 30.29 34.89 40.19 46.29 53.33 61.43 70.76 81.51 93.89 108.15 124.58 143.51 165.31 190.42 219.35 252.67 291.05 335.279.77 11.26 12.96 14.93 17.20 19.82 22.83 26.29 30.29 34.89 40.19 46.29 53.33 61.43 70.76 81.51 93.89 108.15 124.58 143.51 165.31 190.42 219.35 252.67

8.48 9.77 11.26 12.96 14.93 17.20 19.82 22.83 26.29 30.29 34.89 40.19 46.29 53.33 61.43 70.76 81.51 93.89 108.15 124.58 143.51 165.31 190.427.36 8.48 9.77 11.26 12.96 14.93 17.20 19.82 22.83 26.29 30.29 34.89 40.19 46.29 53.33 61.43 70.76 81.51 93.89 108.15 124.58 143.51

6.39 7$ 8.48 9.77 11.26 12.96 14.93 17.20 19.82 22.83 26.29 30.29 34.89 40.19 46.29 53.33 61.43 70.76 81.51 93.89 108.155.55 6.39 7.36 8.48 9.77 11.26 12.96 14.93 17.20 19.82 22.83 26.29 30.29 34.89 40.19 46.29 53.33 61.43 70.76 81.51

4.82 5.55 6.39 7.36 8.48 9.77 11.26 12.96 14.93 17.20 19.82 22.83 26.29 30.29 34.89 40.19 46.29 53.33 61.434.18 4.82 5.55 6.39 7.36 8.48 9.77 11.26 12.96 14.93 17.20 19.82 22.83 26.29 30.29 34.89 40.19 46.29

3.63 4.18 4.82 5.55 6.39 7.36 8.48 9.77 11.26 12.96 14.93 17.20 19.82 22.83 26.29 30.29 34.893.15 3.63 4.18 4.82 5.55 6.39 7.36 8.48 9.77 11.26 12.96 14.93 17.20 19.82 22.83 26.29

2.74 3.15 3.63 4.18 4.82 5.55 6.39 7.36 8.48 9.77 11.26 12.96 14.93 17.20 19.822.38 2.74 3.15 3.63 4.18 4.82 5.55 6.39 7.36 8.48 9.77 11.26 12.96 14.93

2.06 2.38 2.74 3.15 3.63 4.18 4.82 5.55 6.39 7.36 8.48 9.77 11.261.79 2.06 2.38 2.74 3.15 3.63 4.18 4.82 5.55 6.39 7.36 8.48

1.55 1.79 2.06 2.38 2.74 3.15 3.63 4.18 4.82 5.55 6.391.35 1.55 1.79 2.06 2.38 2.74 3.15 3.63 4.18 4.82

1.17 1.35 1.55 1.79 2.06 2.38 2.74 3.15 3.631.02 1.17 1.35 1.55 1.79 2.06 2.38 2.74

0.88 1.02 1.17 1.35 1.55 1.79 2.060.77 0.88 1.02 1.17 1.35 1.55

0.67 0.77 0.88 1.02 1.170.58 0.67 0.77 0.88

0.50 0.58 0.670.44 0.50

0.38

Asset

Fully Diluted Per

Share Series A Common108.15 13.18 80.54 27.6181.51 9.93 60.70 20.8161.43 7.49 45.74 15.6846.29 5.64 34.47 11.8234.89 4.25 28.57 6.3226.29 3.20 22.17 4.1219.82 2.42 17.35 2.4714.93 1.82 13.71 1.2211.26 1.37 10.97 0.288.48 1.03 8.48 0.006.39 0.78 6.39 0.00

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Allocation Scenario Example [refers to chart]• Liquidation scenario range: The orange range reflects the

liquidation preference of the Series A exceeds the enterprise

value

• Transaction scenario range: In the blue range, preferred and

common receive pro rata distributions

• In the top range, amounts above $5/share, automatic conversion

or an IPO would likely occur

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IPO Scenario• Reflected as part of a normal distribution range here but could

also be a discrete outcome in the PWERM

• Each outcome can be tested in the binomial model due to the

transparency

• For example, at outcomes above $41MM, each class receives its

pro rata share of the value

• At asset value of $61.43 x 25.52% = $15.68, common stock value

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Results of Using Latest Round Post-Money Value• Post-money value is a mechanism to allocate future share of the

company should all classes of equity be treated equal

• If the post-money value is used as the starting point in the option

model or results from probability-weighted scenarios, the value of

the current round is distorted and results in a non-meaningful

common allocation (see chart on next slide)

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• Preferred priced at 19% premium on "day 2"

• Common priced at 43% premium

Original

Issue

Price

Based on

Series A

Price EV

Based on Pre-

Money Term

Sheet EV

Series A Preferred Stock $ 1.6600 $ 1.66 $ 1.97

Common $ - $ 0.53 $ 0.76

Total $ 1.37 $ 1.66

Comparison of Latest Round Results

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Solve-for Value• A reasonableness check or alternative method for calculating the

enterprise value can be used

• The constant is that the latest round price must approximate the

model allocation

• For the option model, this means finding the enterprise value that

results in the issue price of the latest preferred

• The issue price of the preferred, not common

• For the PWERM, this means that the selected inputs such as

probabilities, liquidity event values, and present value discount

rates should result in a value allocated to the preferred value

consistent with the latest round price

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A Few Caveats About A Few Caveats About Using the Practice AidUsing the Practice Aid

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Factors Not Considered in the Enterprise Value Allocation Methods Per the Practice Aid• Economic - Liquidity

− Mandatory redemption rights and registration rights, whose

objective is to enhance preferred stock liquidity; and first refusal

rights and co-sale rights, whose objective is to protect preferred

value

• Economic – Valuation

− Antidilution rights, protecting against future declines in value

• Control (and Influence)

− Voting rights, protective provisions and veto rights, board

composition rights, drag-along rights, co-sale rights,

management rights, and information rights

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How to Adjust for Future Levels of Cash and Debt• Estimate future use or generation of

cash?

• Amortize debt?

• Factor in option proceeds?

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Using the PWERM• Do the probabilities represent an additional adjustment for risk?

How do the probabilities affect the discount rate?

• How many scenarios to consider? How to determine a liquidity

date?

• Does a venture backed company ever elect to “remain private”?

• How to handle the dilutive effect of future financings?

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Application of Minority Interest Discounts• Applicable to the “remain private” scenario and not the “future

sale scenario?

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Discount for Lack of Marketability• Applicable to only the “remain private” scenario?

• When does the discount rate already include a discount for lack of

marketability?

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How to Handle the How to Handle the Discount for Lack of Discount for Lack of Control (DLOC) and the Control (DLOC) and the Discount for Lack of Discount for Lack of Marketability (DLOM)Marketability (DLOM)

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How to Handle DLOC and DLOM• Sharp difference between IRS and SEC perspectives

• Factors to consider with discounts for lack of control and lack of marketability

− Option or scenario model dependent

− Starting enterprise value dependent

− Company stage of development/time to liquidity

− Path or scenario dependent

− Company enterprise perspective or individual perspective

− Dilution from future financing rounds

• Discounts based on disproportionate rights (see table on next slide)

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How to Handle DLOC and DLOM

Interests of Preferred Stockholders Compared with Common

Less Aligned More Aligned Fair value below liquidation

preference Significant fair value above

liquidation preference Fair value is between the

liquidation preference of preferred, but less than the conversion price in non-participating preferred

Fair value is above conversion threshold of non-participating preferred

No automatic conversion, significantly below automatic conversion price or transaction type does not require conversion

Automatic conversion, likely scenario is IPO with automatic conversion

Additional financing rounds required; resulting in disproportionate dilution to common

No additional financing necessary

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Use of Quantitative Models for Discounts

• Advantage: Can be audited

• Disadvantage: Subject to garbage-in, garbage-out and dangerous

when used without other analysis and judgment

• Disadvantage: Appeal of math clouds judgment of applicability

• Advantage: Addresses key SEC concerns of volatility and

duration

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Quantitative Models Seen Used• Restricted stock regression analysis (i.e., Longstaff)

• Put option

• Put-call collar

• Proprietary models

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Additional Commentary on Quantitative Models

• Theoretical models built off liquid security data

• Do not reflect the costs of executing the derivative strategies

• Locks in a price today, doesn’t reflect present value impact of

receiving a specified price in the future

• Proprietary models cannot be audited

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Tips for Producing a Tips for Producing a Report That Satisfies Both Report That Satisfies Both Goals: Tax and Financial Goals: Tax and Financial ReportingReporting

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Tips for Producing a Report• Follow the Practice Aid

• Consult with the auditor as necessary

• Be aware that there will be a need to update the report annually

if not more often

• Will the assumption result in a material impact on financial

statements if reasonable professionals would come up with

difficult assumptions?

• If the assumptions are material, what can be done to support why

another assumption would not be more appropriate?

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Tips for Producing a Report [continued]• Perception matters in valuation for accounting purposes,

motivations in stock option grant price setting are well known

• Since methods are still evolving, there are gray areas of

interpretation

• The best approach is to consider the big picture, step back, and

determine whether the conclusions are reasonable rather than to

take the Practice Aid or any other tool and use form over

substance

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Questions?• Email [email protected] at any time during the

Teleconference

• The conference operator will provide instructions on how to ask live

questions

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Thank You for Attending!• Visit www.bvresources.com/conferences for a schedule of exciting upcoming

sessions, as always, Teleconferences are good for two CPE credits

• May 23rd, Playing and Prospering By the New Valuation Rules featuring Al King and

Matt Crow

• May 24th, Overview of Buy-Sell Agreements (part 1 of 3) featuring Chris Mercer

• May 31st, Lost Profit Damages featuring Nancy Fannon, Robert Gray and Thomas

Burrage

• June 14th, Application of Buy-Sell Agreements (part 2 of 3) featuring Chris Mercer

• June 26th, Recruiting in the BV Profession featuring Jim Alerding, Megan Nail and Ron

Seigneur

• June 28th, ESOP Valuation featuring moderator Robert Reilly

• July 19th, Buy-Sell Agreements and Valuation Related Issues (part 3 of 3) featuring

Chris Mercer

• July 25th, Electronic Discovery featuring Ron Seigneur, Melinda Harper and Shari Lutz

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CPE Credits• All BVR Teleconferences are worth two interactive CPE credits

• Be sure to complete the post-conference survey within five

business days: http://www.bvresources.com/defaulttextonly.asp?

f=tcsurvey050207

• You should receive your CPE certificate via email within one week

Business Valuation Resources

1000 SW Broadway, Ste. 1200, Portland, OR 97205

1-888-BUS-VALU (287-8258) / Fax: 503-291-7955

www.bvresources.com

[email protected]

1 business valuation resources teleconference may 2 nd, 2007 – 409a compliance – issues,...

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