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Employee Stock Options: Tackling Complex Tax,

Accounting, and Valuation Challenges

WEDNESDAY, MARCH 25, 2020, 1:00-2:50 pm Eastern

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March 25, 2020

Employee Stock Options: Tackling Complex Tax, Accounting, and Valuation Challenges

Justin Kuczmarski, MBA, CPA, CVA, ABV, CEIV, CIRA, CFF, President

NAV Valuation & Advisory

[email protected]

James A. Guadiana, Partner

Barton

[email protected]

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

Employee Stock Options:

Tackling Complex Tax, Accounting,

and Valuation Challenges

Navigating IRC Section 409A, FASB Requirements, and the

AICPA's Practice Guide to the Valuation of Options

March 25, 2020

March 25, 2020 Webinar: Employee Stock Options: Tackling Complex Tax, Accounting, and Valuation Challenges

Presentation Table of Contents

Table of Contents Page(s)

Speaker Bios 3

Section 1: Guidance in IRC 409A and ASC 718 6

Section 2: Equity and Business Valuation Methodologies 15

Section 3: Incentive Stock Options, Nonqualified Stock Options, and Valuation Structuring

29

Section 4: Option and Warrant Valuation, DCF Method Tips 40


Speaker Bios

James Guadiana, Esq.(212) 885-8837 * [email protected]

Jim Guadiana, Esq. is a Partner at Barton LLP. Jim focuses his practice on the tax aspects of domestic andinternational transactions and investments. He serves as advisor to public and privately-held multinationalcompanies and investment firms with regard to their operations and investments in the United States. Jim alsohas extensive experience as tax advisor to a number of public corporations listed on the London, Hong Kong, andToronto stock exchanges. Jim is respected domestically and internationally for his ability to identify and resolveunique and complex tax issues in domestic and cross-border investments in a myriad of fields. Jim also hasrepresented clients before U.S. tax agencies and U.S. tax tribunals.

Jim routinely advises clients on the establishment of transfer pricing policies, and assists clients in implementingbeneficial cost-sharing and other arrangements. He counsels public and private companies on preservation of netoperating losses and provides planning on various cross-border sales of physical commodities and relatedhedging transactions. Jim instructs issuers and investment banks regarding the treatment of foreign corporationsas to their status, or avoidance of status, as passive foreign investment companies (“PFICs”). He structuresmultinational executive compensation programs to achieve optimum tax benefits for employers and employees inmultiple jurisdictions. Jim advises clients on the tax aspects of transfers of proprietary technology, includingpatents. He counsels multinational families with regard to their global investments, business activities and U.S.tax compliance requirements.

Jim has served as U.S. tax counsel to one of the world’s largest companies in its pre-IPO reorganization and IPO,advising it on complex U.S. tax and executive compensation matters. He has served as tax advisor for U.S. realestate development projects, providing both pre- and post-formation tax planning, and structuring investmentvehicles to optimize after-tax returns for foreign investors.

Prior to joining Barton, Jim was a Partner in the New York Office of the international business law firm, Torys LLP.


Justin Kuczmarski, MBA, CPA, CVA, ABV(212) 418-1234 * [email protected]

Mr. Justin Kuczmarski, MBA, CPA, CVA, ABV, CEIV, CIRA, CFF, is the President of NAV Valuation & Advisory LLC (“NAV”).

Prior to founding NAV, Mr. Kuczmarski served as a NYC Practice Leader in Financial Advisory Services for a top 10accounting and advisory firm. He also has senior M&A investment banking experience as a Valuation Practice Leader for aleading M&A boutique bank.

He holds three leading valuation credentials/licenses (CVA, ABV, CEIV), two credentials/licenses in public and forensicaccounting (CPA and CFF), and one in bankruptcy and restructuring advisory (CIRA).

In 2011, he was a Finalist for Crain’s New York Top 40 under 40. In 2016, Mr. Kuczmarski was a recipient of the NACVA 40Under 40 from the nation's leading valuation association, the National Association of Certified Valuation Analysts (NACVA).He is also frequent TV commentator on technology valuation and M&A for networks such as i-24, CCTV, and CGTN.

Mr. Kuczmarski possesses a unique background combining senior experience in both M&A investment banking and financialadvisory services. He brings a strong, real-world M&A experience to his delivery of valuation services, financial advisory,forensic support, and M&A corporate finance. He has led or participated in over 150 transactions since 2000.

He specializes in the following industries: construction and real estate, asset management, business services, healthcare,and technology. Notable clients include some of the nation’s leading alternative investment funds, law firms, and privatebusinesses. In 2013-14, Mr. Kuczmarski led the due-diligence and initial public market valuation / pricing of two high-profile technology IPOs. He has also successfully defended his analysis before the IRS in multiple tax compliance appraisals.Mr. Kuczmarski has performed and reviewed thousands of fund valuations during his career.

He is frequently approached to serve as a litigation expert consultant or litigation expert witness, and he has been retainedin several billion dollar commercial cases throughout his career. Mr. Kuczmarski is the sole author of the 300-pageguidebook entitled The Executive’s Guide to Business Valuation: Essentials for Advisors and Business Owners.

Mr. Kuczmarski received a B.A. in Politics from Princeton University. He also received an MBA from Fordham University inboth Finance and Professional Accountancy, where he attended on full academic fellowship.



Section 1: Overview of authoritative guidance in

IRC 409A and ASC 718


Multiple Valuation Rules for Stock Options

Stock options granted to executives who are employed by corporations with GAAP accounting are simultaneously subject to different valuation rules which have separate objectives. To summarize:

The grant of an option (ISO or NQO) generally doesn’t result in compensation being recognized for regular income tax purposes (no gross income for the executive and no deduction for the employer corporation). This is based on the long standing rule in the Treasury Regulations that the grant of a stock option that does not have a “readily ascertainable fair market value” will not be a compensatory event for tax purposes unless similar options are traded (which is generally not the case). Many have criticized this rule as being unreasonable and outdated but any departure from it can be expected to be met with a strong challenge from the IRS.

However. Even though the option grant is not a taxable event, the fair market value of the shares subject to the option must still be determined in order to comply with the exemption from 409A, i.e., the option price must be no less than the shares’ value at the time of option grant.

Inconsistent with the income tax rules, ASC 718 requires that the option be valued and amortized as an expense against income.


IMPACT OF 2017 TAX CUTS AND JOBS ACT (TCJA)TAX REFORM-C CORPORATION

Marginal Tax Rates on Equity Based Compensation

Executive:

▪ Phantom stock, SARs, RSUs, Income on exercise of NQOs-compensation (ordinary income)-37% plus Medicare tax (3.8%), or

▪ Capital gain 20% plus Medicare tax (3.8%) upon sale of shares

Employer

▪ C Corporation will deduct the compensation at a federal marginal rate of 21%.

▪ But no deduction for income Executive recognizes as capital gain and not compensation.


Pre-2017 TCJA

$100 of compensation is paid to the executive. Executive included the income at 45% (includes state and local tax (“”SALT”) after federal benefit) and the C Corporation deducts this $100 compensation against income taxable at 40%.

After taxes executive had $55 which cost the corporation after tax savings $60.

Post-2017 TCJA

After tax reform executive will be subject to tax at 45% (taking into account SALT is

not deductible). The employer, a C Corporation (assume 21% federal and 7% SALT after federal benefit will deduct this $100 against 28% income.

▪ The executive will have $55 after taxes on the $100 payment (same as prior law) but will “cost” the C Corporation $72 instead of $60.

▪ Observation: after taxes, compensation paid to executives will “cost” more than under prior law.

▪ This compensation will include not only base salary plus bonus, but also ordinary income rate is from the exercise of NQOs and SARs.

Comparison of Before and After TCJA


Impact of Tax Reform: C-Corp Summary

▪ If the employer is a C corp. consider granting “incentive stock options” (“ISO”s). ISOs provide total capital gain but must satisfy certain statutory requirements. Also, size of grant is limited.

▪ NQOs provide capital gain only on post exercise appreciation.

▪ For a stock option to qualify as an ISO, the option and optionee must meet certain requirements when the option is granted.

▪ Consider using “founder shares” instead of stock options. Better tax treatment for executive and 409A does not apply.


Section 409A-In General

▪ Section 409A was enacted in reaction to the abuse of anticipatory withdrawals of executive compensation which became apparent with Enron.

▪ Unless an exemption applies, a nonqualified deferred compensation plan can permit service providers to exercise options only on one or more of the following payment events:

1. separation from service;

2. disability;

3. death;

4. a specified time or pursuant to a fixed schedule;

5. a change-in-control;

6. the occurrence of an unforeseeable emergency.

Thus, without an exemption from 409A, a plan can provide the service provider with the right to exercise the stock option in only one specified taxable year, or on a permissible payment event, such as separation from service or change-in-control. Thus, in order to provide the flexibility to exercise a stock option at any time after vesting, i.e., enabling the service provider to have the flexibility to choose when to exercise the stock option, compliance with the rules described below is necessary.


Section 409A-In General (Cont’d)

▪ Severe tax penalties under apply in the case of a non-compliant stock option:

▪ Any unrealized gain in the options as measured on December 31 of the vesting year is reportable as section 409A income and taxable to the option holder in the year of vesting whether or not the options have been exercised.

▪ Further, in each subsequent year prior to the exercise of the options, any additional unrealized gain as measured on December 31 of such year is includable as section 409A income.

▪ The amounts so taxed as income serve to increase the option holder’s tax basis in the options to avoid “double taxation” of the previously taxed income in the year the options are actually exercised.

▪ Effectively, the optionee is taxed on income the optionee does not actually receive, from shares that may not then or ever be saleable.


Section 409A-In General (Cont’d)

▪ The employer is required to report the section 409A failure on the employee’s Form W-2 and to withhold tax on the “409A income.” Failure to do so could result in penalties to the employer.

▪ The 409A income is subject to an additional 20 percent Federal tax imposed under section 409A on the option holder. This is in addition to the option holder’s regular income tax.

▪ An additional premium interest may also be imposed on the section 409A income at the rate of 1 percent above the IRS underpayment rate. Although computed like interest, this is a tax that itself may be subject to interest and penalty charges.

▪ it is not uncommon for the executive to seek a “gross-up” payment for these penalty taxes.

▪ While the statute itself refers only to service providers to corporations, IRS Notices have extended its rules to apply to grants of executive compensation to executives of both corporations and partnerships (including LLCs).


Section 409A and Valuation Issues

▪ The grant of an incentive stock option is not a deferral of compensation under 409A.

▪ For a nonqualified stock option to be exempt from 409A,

➢ The exercise price may never be less than the fair market value of the underlying stock on the date the option is granted

➢ the receipt, transfer or exercise of the option must be subject to taxation under §83;

➢ the option does not include any feature for the deferral of compensation other than the deferral of recognition of income until the later of exercise or disposition of the option.

➢ Generally, the option must be granted by the service recipient or its parent.

▪ Companies can establish a defensible FMV by using an IRS-approved valuation method.


Section 409A and Valuation Issues

▪ How to determine the fair market value of a share of illiquid stock of startup?

▪ Fair market value of the stock of a company that is not readily tradable on an established securities market determined by the consistent application of a reasonable valuation method. Whether a valuation method is reasonable, or whether the application of the valuation method is reasonable, is determined based on facts and circumstances

▪ Safe Harbor Valuation Methods That Comply with IRS Section 409A

▪ Independent Valuation. Hire an independent, outside qualified appraiser to do the valuation. The third-party appraiser must be allowed full access for an assessment and take into consideration all available information material to the valuation of the company’s common stock. Valuations for 409A purposes must be updated any time that there is a material change event that could alter the value of the stock. Material change events include receiving a term sheet for financing, receiving new financing, settling a lawsuit, or filing a patent. Valuations must also be updated based on elapsed time, even if there is no material change event. In general, in the absence of a material change event, a valuation is considered to be valid for just 12 months.


▪ Illiquid Startup Inside Valuation. If a startup is not yet big enough or established enough to afford the costs of an independent valuation, an inside valuation may be acceptable. In order to qualify to rely on the illiquid startup insider valuation safe harbor method, a company must have:

▪ Been in business for no more than ten years;

▪ No publicly traded securities;

▪ No reasonable expectation of being acquired in the next 90 days or going public within the next 180 days; and

▪ No common stock subject to put or call rights or other similar obligations.

▪ A concern here, however, is fear of exposing to liability the company’s internal finance experts.

Section 409A and Valuation Issues (Continued)


Formula Price upon Buyback from Employees

Some corporations owned predominantly by its employees require stock to be repurchased upon separation from service. In this connection, Treasury Regulations under Sec. 83 provide reliable guidance on determining closely held shares acquired in an employment context. Treas. Reg. Sec 1.83-5(a) provides:

▪ Valuation. — For purposes of section 83 and the regulations thereunder, in the case of property subject to a nonlapse restriction (as defined in § 1.83-

3(h)), the price determined under the formula price will [generally] be considered to be the fair market value of the property unless established to the contrary by the Commissioner, and the burden of proof shall be on the commissioner with respect to such value. If stock in a corporation is subject to a nonlapse restriction which requires the transferee to sell such stock only at a formula price based on book value, a reasonable multiple of earnings or a reasonable combination thereof, the price so determined will ordinarily be regarded as determinative of the fair market value of such property for purposes of section 83….


Formula Price upon Buyback from Employees (Cont’d)

A nonlapse restriction is defined as:

▪ Treas. Reg. § 1.83-3(h) Nonlapse Restriction. — For purposes of section 83 and

the regulations thereunder, a restriction which by its terms will never lapse (also referred to as a “nonlapse restriction”) is a permanent limitation on the transferability of property [w]hich will require the transferee of the property to sell, or offer to sell, such property at a price determined under a formula, and [w]hich will continue to apply to and be enforced against the transferee or any subsequent holder (other than the transferor).

▪ A limitation subjecting the property to a permanent right of first refusal in a particular person at a price determined under a formula is a permanent nonlapserestriction. Limitations imposed by registration requirements of State or Federal security laws or similar laws imposed with respect to sales or other dispositions of stock or securities are not nonlapse restrictions. An obligation to resell or to offer to sell property transferred in connection with the performance of services to a specific person or persons at its fair market value at the time of such sale is not a nonlapse restriction.


▪ According to ASC 718, a company that issues equity as compensation needs to list a compensation expense on its income statement that corresponds to the estimated cost of those equity grants.

▪ If you work at a tech startup, often your compensation has two parts: salary and equity.

▪ It’s easy to show salaries as an expense, but under GAAP, the government also wants to see an expense for the equity portion of employee’s compensation.

▪ Do you need to calculate ASC 718 expense?

What is ASC 718?


Expense for the Equity Portion of Employee’s Compensation

▪ There are two questions to ask when a company is trying to decide whether or not they need to complete the equity grant expense report:

1.Do you have employee equity grants? These could include:

▪ Options (ISOs and NQOs)

▪ Employee stock Purchase Plans

▪ Restricted stock units (RSUs)

▪ Stock appreciation rights (SARs)

▪ Restricted Stock Awards (RSAs) where the recipient did not pay fair market value for the shares.

▪ [As the program title states, we will be discussing only options.]

2.Do you have audited financials?

▪ Where the answer to both 1 and 2 is yes, then the determination of option expense is generally required.


ASC 718

Two steps to calculating the ASC 718 Expense:

Step 1: Valuing the Options- Determining what each option is worth.The value of the options is not the same as the value of a common share for 409A valuation. A 409A valuation results in a value per common share.

While the stock value for 409A purposes is used to set the strike price for the options, the options have a distinct value different from the 409A price.

Options have value based on the future potential upside of the company. For ASC 718, options are typically valued using the Black-Scholes calculation to quantify that future value. Justin will discuss this valuation method.


Step 2: Amortizing the Expense:

GAAP accounting for stock options requires that the expense be spread across its useful life, which is typically defined as the option’s vesting life.

In Step 2, the expense is spread out so that it matches the vesting of the option.

Option Expense ExampleE is granted 100,000 options, and using the Black-Scholes calculation, the employer determines that his options are worth $0.10 apiece.

Assume that 25% of his options vest on December 31st each year for 4 years.

Based on that info, we would book an expense of $2,500 in each year (25,000 options x $0.10 each).

Special rules apply when forfeitures occur.


Section 2: Equity and Business Valuation Methodologies


Valuation “Ballparks”: When Equity Compensation Scenarios Arise

Securities Valuation

M&A Valuation Opinions

M&A

Financial

Due-Diligence

Employee Transition and Succession

Planning

Shareholder Buyouts and Shareholder

Litigation

Bankruptcy and Restructuring

ESOPs & Employee Retention

Business Valuation

Standalone FinancialAdvisory

Transactional Financial Advisory


Types of Equity Awards:

Preferred Equity

Common Equity

Restricted Shares

Incentive

Shares

Phantom Shares

Warrants

Options

More Junior More Senior


Business Valuation: Approaches and Methods

▪ The market approach is often seen as a “sanity check” on private equity valuesince two of the three standard valuation methods are market-driven.

Asset Approach

Adjusted Net Asset Method

Market Approach

Public Company Method

M&A Method

Premium Analysis

Prior Transactions (Rarely Used)

Rules of Thumb

(Rarely Used)

Income Approach

Direct Capitalization

Method

Discounted Cash Flow

Method

Adjusted Present Value

Method

Indicates most common method


Business Valuation: Triangulation of Methods

▪ In the end, the three standard methods, in addition to any other methodsanalyzed, should triangulate to produce a consistent value range.

▪ The valuator nevertheless examines and researches all applicable methods to test this assumption and document findings in accordance with professional standards and requirements.

Discounted Cash Flow (DCF) Method ($95,000,000)

M&A Method ($105,000,000)

Public Company Method

($110,000,000)

Triangulated Value~ $100,000,000

Market Sanity Check Market Sanity Check


Business Valuation: Key Questions ▪ Some common questions to consider in objectively scrutinizing a business:

Near-Term Risk Long-Term Risk

Key man or key client risk Pending long-term capital expenditures and investments

Pending legal or regulatory changes Industry challenges

Growth trajectory Leadership succession planning

Operating cash flow trend Company strategy and vision

Working capital needs Potential buyers: are there enough legitimate buyers around?

Profitability trend Liquidation scenarios (“dead or alive” principle)


Levels of Value Chart


Leading Methods for Early-Stage Company Valuation:Enterprise Value Allocation

OPM

(Option Pricing Method

PWERM

(Probability-Weighted Expected Return Method)

Current Value Method

(CVM)

Hybrid Method

(New Method, Uses 2 or More Equity Allocation

Methods)


Equity Allocation: Why OPM is Dominant Allocation Method

• OPM is the most prevalent equity allocation method.

• OPM is more suited to early-stage companies that are less developed. The valuator modelseach equity class (preferred equity, convertible debt, debt, common equity, warrants, options)as a call option with a claim on the EV, or enterprise value, of the Company.

• Financial theory refers to the OPM method also as the Contingent Claims Method. Every classof security is valued using an assumed fully diluted capital structure where each class isassumed converted.

• Option exercise values generate the value of each capital tranche and the correspondingcomplex capital structure waterfall. The total enterprise value, determined in a businessvaluation, helps create the starting point for the equity allocation “waterfall”. Businessvaluation is first and equity allocation “carves up” the pie.

• The key in OPM is modelling out common and preferred equity classes, as well as any debtclasses, to incorporate “payoff diagrams” of regular call options at the assumed liquidityevent.

• The specific characteristics of each equity class, from preferences, years, and conversionfeatures, help drive the class’s claim on the overall equity value. Characteristics driveequity allocation.


OPM: Pros and Cons of Leading Allocation Method

• OPM is very useful for valuing securities when significant uncertainty regarding futurerevenue, earnings, and potential future outcomes remains strong.

• The latter is why auditors and financial managers / CFO are keen on the OPM method. SeeAICPA Equity Compensation Guide (2017) and AICPA’s new, 2019 Guide for Valuing PrivateEquity and Venture Capital.

• The OPM is also an attractive methodology through analyzing differences among equityclasses on a prospective, forward-looking basis.

• OPM usually does not require as many assumptions as other equity allocation methods suchas the PWERM.

• A weakness in OPM is that the OPM method is very sensitive to the underlying assumptions ofthe Black Scholes or binomial models employed, particularly with respect to firm volatility. Iwill discuss volatility analysis shortly.


OPM: Pros and Cons (Continued)

• A valuator derives a substantiated volatility opinion, using 1) public company asset volatilitystarting points, 2) size-adjustment, and leverage-adjustment. The AICPA advocates a size-adjustment and leverage-adjustment to volatility.

Keys Inputs in Valuing Volatility for OPM Equity Allocation or Black-Scholes Method (Options, Warrants)

• Do not use equity volatility purely from public companies without considering orincorporating these three adjustments.

• One risks violating GAAP or a financial statement adjustment since volatility is key to a BlackScholes OPM and Black Scholes method for valuing options and warrants.

• It is key to remember how OPM is not a valuation method. OPM is an allocation of enterprisevalue, which is from the valuation method results.

• The Backsolve OPM, introduced a few years ago, states that when any component of thecapital structure is known – through primary issuance, deal, or secondary trade – theenterprise value uses that implied value to work backward from output to an indication ofequity values across tranches.

Asset Volatility from Public Comps

Size-Adjustment Leverage Adjustment


PWERM, Current Value Method, and Hybrid Method

• PWERM is centered around decision-tree analysis and modeling.

• PWERM computes the probability weighted expected returns, or potential future expectedoutcomes.

• Under PWERM, the valuator derives the value of common stock from a weighted analysis offuture values for the enterprise assuming various scenarios.

• PWERM is beneficial for later-stage companies.

• Hybrid Method blends OPM and PWERM.


Current Value Method

• The Current Value Method (CVM) uses the enterprise value from more traditional valuationapproaches as of the valuation date. The enterprise value is next allocated amongst thevarious equity classes based on their liquidation preferences or their conversion values.

• CVM allocation stems from whichever value, at liquidation or conversion, would be greater.

• CVM’s advantage is how allocation method is relatively clear and straightforward.

• CVM deficiency stems from how CVM lacks the forward-looking perspectivenecessary to appropriately value many early-stage securities.

• CVM is method is limited to situations in which (i) liquidation of the enterprise is eminent and(ii) expectations about the future going concern value of the enterprise are impractical.


Section 3: Incentive Stock Options, Options, and

Valuation Structuring Insights


Incentive Stock Options

▪ On the date the option is granted, the optionee must be an employee of the C corporation (or its subsidiary)

▪ Option must be granted pursuant to a written plan approved by the shareholders

▪ The maximum aggregate number of shares that may be issued under the plan through ISOs must be fixed when the plan is adopted

▪ Ten-year duration of the plan. The plan cannot have a duration that exceeds 10 years from the earlier of the date the plan is adopted or the date the plan is approved by the stockholders.

▪ Option terms are exercisable up to a 10-year period.


Incentive Stock Options

▪ Options are not treated as ISOs (but instead are treated as NSOs) to the extent that the aggregate fair market value of stock with respect to which ISOs are exercisable for the first time by any individual during any calendar year (under all plans of the individual's employer corporation and its parent and subsidiary corporations) exceeds $100,000.

▪ Fair market value of the stock is determined as of the date of grant of the ISO.

▪ An option is considered to be first exercisable during a calendar year if the option first will become exercisable at any time during that year, assuming that any condition on the optionee's ability to exercise the option related to the performance of services is satisfied.

▪ Option exercise price must be not less than 100% of the fair market value of the stock that is subject to the ISO, as measured on the date the option is granted. In the case of 10% owners, the option exercise price must be not less than 110% of such fair market.

▪ Because the shares are not publicly traded Valuation is more difficult. In the case of Closely held corporations (including S corporations) this can be handled by a “nonlapse restriction”. (See “Valuation of Shares” below).

▪ This is, perhaps the toughest task in adopting an ISO Plan for executives of a closely held company.


Incentive Stock Options (Cont’d)

An ISO plan or the ISO agreement may contain provisions other than those discussed above,if they are not inconsistent with the above restrictions.

Such provisions could include for example:

▪ option vesting,

▪ the right to pay the exercise price with corporation stock or promissory notes, same-day-sale arrangements (sometimes referred to using the misnomer “cashless” exercise arrangements),

▪ stock appreciation rights (including a tandem ISO/SAR in certain circumstances), ▪ rights of first refusal in favor of the corporation,

▪ a right in favor of the corporation to redeem the stock on termination of employment, or acceleration of vesting upon a change of control of the corporation.

▪ Although qualifying ISO dispositions can be reported as long-term capital gains, the bargain element at exercise is also a preference item for the alternative minimum tax.


Disqualifying Dispositions

▪ Employer corporation entitled to tax deduction;

▪ No withholding but employee must pay tax on compensation element;

▪ ISOs are not available to service providers of partnerships (including LLCs).


Partnerships and LLCs

If the executive is employed by a partnership or an LLC treated as a partnership for tax purposes, the partnership’s executives could be granted “profits interests” without incurring tax on the receipt of such interests, and

▪ Eligibility for the 20% deduction for “qualifying business income”; and

▪ Opportunity for capital gains upon sale or tax-free exchange treatment upon an IPO.


20% deduction for qualifying business income ("QBI")

▪ Individuals who are S corporation shareholders or partners in a partnership (or members ofan LLC treated as a partnership) or owners of a sole proprietorship, are subject to tax atthe individual owner or shareholder, partner or owner level rather than the entity level. Netincome earned by such holders of interests in these entities report their share on theirrespective income tax returns and are subject to ordinary income tax rates, up to the topindividual marginal rate (37% under the Act).

▪ Generally, for years beginning after 2017 and before 2026, the Act allows a deductionequal to 20% of "qualified business income" ("QBI") derived by such interest holders.Individuals may benefit meaningfully from this proposal, since QBI income that wouldotherwise be subject to a 37% maximum rate may be eligible for a maximum effective rateof 29.6%.

▪ However, the QBI deduction is limited to the greater of the owner's share of (i) 50% of theamount of W-2 wages paid to employees by the qualified business during the tax year, or(ii) the sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.


Downside of stock options

▪ ISOs can only be used in limited cases as noted above.

▪ Nonqualified options will result in substantial compensation taxable as in an amount equal to the value-add exercise over the option price. Marginal rate for executive is 40.8% federal (37%+3.8 Medicare tax).

▪ In the case of a corporation in its early stages or pre-IPO where the position of low stock value exists, consider granting “founders shares” so that all post-grant appreciation will qualify for capital gain treatment. In the event the grant is subject to a substantial risk of forfeiture, a section 83(b) election will be necessary.

▪ However, to the extent employee recognizes ordinary income, the Corporation will be entitled to a deduction.


Section 4 Option and Warrant Valuation, DCF Model Best Practices


Size-Adjusting Public Comp Multiples: Suggested Tips

• Size-adjustment is commonplace amongst the valuation community

• Size-decile adjustments for multiples is more reliable than growth adjustingsince many niche industries lack sufficient Analyst growth rate coverage

• Mar

• Source: Financial Valuation, 3rd Edition. Copyright 2011 by Wiley & Sons. Pages 305 to 307


Size-Adjusting Public Comp Multiples: Suggested Tips


Discount for Lack of Marketability (DLOM) Analysis

▪ There is no specific guidance in either the AICPA Practice Aid entitled Valuation of Privately Held EquitySecurities Issued as Compensation (the “Aid”) or other valuation sources on the precise quantitative DLOMput option model to utilize.

▪ Large national accounting firms, particularly the valuation reviewers at the accounting firms,favor the quantitative, put option methods for valuing the DLOM. Independent valuators who practicein financial reporting valuation also heavily utilize put option DLOM models to ensure all practitioners,whether valuation reviewers or independent providers, are on same page.

▪ Put option methods are Black Scholes option pricing methods. The five Black Scholes inputs are again frontand center.

▪ Some valuators have noted that the Finnerty revised model is the leading DLOM to apply.

▪ However, the Ghaidarov model has been widely utilized by the valuation profession since 2009. TheGhaidarov DLOM put option model alters the adjusted Finnerty put-option DLOM model to correct forlimitations Finnerty has acknowledged. For example, Finnerty personally acknowledged an error in hisadjusted Asian-put model in a 2009 valuation conference.

▪ NAV team utilizes the Ghaidarov put option DLOM model, Finnerty revised put option DLOM model,qualitative analysis, and various databases in our fund and private company practices.

Strike Price Current Price/Value

Time to Expiration

Risk-Free Rate

Volatility


Volatility Analysis: Wrong Way To Apply to Private Companies

• The old volatility approach, that is now maligned by auditors and valuators, is to select an equityvolatility from industry public companies as a proxy for private company volatility in a BlackScholes method.

• The AICPA, in the Equity Compensation Aide and in ASC 718, has created more-detailed guidelines forvolatility. The guidelines state valuators perform an analysis of leverage, size, and to consider all relevantfactors.

• The process is mathematically complex in Excel and involves iterations, Excel’s solver function, and possiblesimulation.

• It is often a six to eight-hour process per valuation / option date to document the various steps across tens ofpublic companies for a detailed data set . The volatility input is critical since the input drives the sensitivity foroptions, warrants, and the OPM equity allocation method, which is the dominant equity allocation method.

• CFOs are outsourcing the liability of the key assumption. Why? An auditor challenge to volatility will cause arestatement of option expense and hence historical income statements.

• Volatility is often above 70% for tech firms or biotech firms, two large sectors for complex equity valuation.

• Please see a redacted sample volatility opinion at the following link:


DCF Theory: Standard Steps

• Develop projected earnings (management projection)

• Convert projected earnings to expected cash flow

• Estimate the “terminal” value

• Develop a risk-adjusted discount rate

• Discount the discrete cash flows

• Discount the terminal value

• Sum the PV of the discrete cash flows and the terminal cash flow

• Subtract interest-bearing debt (assuming cash flows represent returns availableto both debt and equity investors)


DCF Method: Leading Errors

• Applying the same WACC to value a different division or operatingsegment that has a different risk profile.

• For diversified firms with business segments both “above” or “below” the line, thiswould be technically inappropriate due to the different risk profiles facing eachbusiness segment.

• Discounting the terminal value at the present value factor for n + 1periods rather than at the present value factor for n periods.


DCF Error: Wrong PV Discount Factor for Terminal Value


DCF Error: Wrong PV Discount Factor for Terminal ValueProper way to discount the terminal value

• The terminal cash flow is discounted to a present value based on the estimated WACC and the number of periods the terminal cash flow is anticipated to be received in the future

• The terminal value is assumed to represent the beginning of the period value of total anticipated cash flow for all periods following the end of the discrete projection period

• Therefore, the terminal value typically is discounted for the samenumber of periods as the last cash flow in the discrete projectionperiod:

TCF

PV = (1+k)4.5


DCF Error: Wrong PV Discount Factor for Terminal ValueCase Study

• M&A Application: CFO Inadvertent Mistake Leads to Restatement ofEquity Compensation

• CFO historically used the present value factor for the terminal period as n + 1rather than n.

• This led to a major restatement of equity grants since the DCF value was the onlyinternal management valuation method for valuing these private share grants.


DCF Theory: Leading Errors (Continued)

• Failure to Define Changes in DFNWC (Debt-Free Net Working Capital) asthe Incremental Change in DFNWC as a percentage of IncrementalChange in Revenue

• Why is this important? Subtracting DFNWC as a percentage of revenue mayoverstate this free cash flow subtraction component and hence understate equityvalue due to a higher subtraction for DFNWC.

2017 2018 2019

Revenue 100 200 300

Debt-Free Net Working Capital (DFWNC)

10 15 18

DFNWC as a % of Revenue (Wrong Assumption)

10.0% 7.5% 6.0%

Wrong Subtraction for DFNWC ($10.0) ($15.0) ($18.0)

DFNWC as a % of Incremental Revenue (aka Revenue Change) Assumption

5%(5 / 100)

3%(3 / 100)

Proper Subtraction for DFNWC ($5.0) ($3.0)


DCF Error: Wrong DFNWC Definition

• Definition of Free Cash Flow to Equity and Free Cash Flow to Firm

Changes in DFNWC defined as

Change in DFNWCChange in Revenue

This is the Incremental Change

in DFNWC

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