straight talk on 409a valuations: getting it right the first time

Straight Talk on 409A Valuations: Getting It Right the First Time

Wednesday, June 6, 2012 @ 2:00 p.m. ET

Administrative Items •  All lines are muted. Please use the Questions Tab to send a question to our

panelists. •  Today's webinar is being recorded and will be sent to all attendees after the event.

What You'll Learn Today •  Why you should consider getting a 409A valuation and the legal, tax, and financial

reporting consequences of non-compliance. •  When is the right time to get your first valuation and how often you’ll need an

update. •  What information you’ll need to provide to your legal, valuation and audit service

providers. •  Common problems and pitfalls you will want to avoid. •  What to do if you are not satisfied with your valuation.

Today's Speakers Dave Broadwin Partner, Foley Hoag LinkedIn: http://www.linkedin.com/in/davebroadwin Twitter: @broadwin Email: [email protected] Online: www.foleyhoag.com Blog: www.eecblog.com

Channing Hamlet Managing Director, Cabrillo Advisors LinkedIn: http://www.linkedin.com/pub/channing-hamlet/0/129/824 Twitter: @cdhamlet Email: [email protected] Online: www.cabrilloadvisors.com

Ed Sullivan Audit Partner, KPMG LinkedIn: http://www.linkedin.com/pub/ed-sullivan/6/36b/818 Twitter: @KPMGed Email: [email protected] Online: www.kpmg.com

Gary Levine CEO, Corporate Focus LinkedIn: http://www.linkedin.com/in/garydlevine Twitter: @TwoStepSoftware Email: [email protected] Online: www.corporatefocus.com

What Is 409A? •  A section of the Internal Revenue Code that governs certain deferred compensation including

options

•  Deferred Compensation is a legally binding right to compensation that arises in one tax year and may be paid in a later tax year.

•  Options are rights to acquire stock in the future.

Dave Broadwin Partner, Foley Hoag

What Are the Consequences of Non-Compliance?

•  Inclusion in income and a 20% penalty tax at the time the right vests •  For options:

o  Income at the time of vesting (even if not exercised) o  20% penalty o  Same tax penalty on each value increase each year


What Payments Are Exempt? •  Payments that meet the short term deferral rule •  Payments that meet the 2 times/2 year rule •  Compliant option grants •  Certain others

o  401(k) payments o  Welfare benefits


Short Term Deferral Rule •  This rule exempts payments made no later than 2 ½ months after the later of (a) employee’s or

(b) employer’s taxable year in which the right to deferred compensation vests.


2 Times/2 Year Rule •  Applies to cases of involuntary termination

o  The payment must be the less than the lesser of (a) 2 times annual compensation or (b) 2 times the IRS limit on compensation for tax qualified plans.

o  Must be paid within 2 years of termination.


Option Issues •  Must be for common stock •  Must be issued for service recipient stock •  Must have an exercise price not less than the fair market value on the date of grant •  Must state a fixed number of shares on the date of grant •  Must be taxable when exercised •  Must not defer income beyond exercise or disposition

•  NB - These rules are for non-qualified stock options. Qualified options have their own exemption and are not taxable when exercised.


Pricing Option Grants •  Guess (toast if you are wrong) •  Internal valuation by a sophisticated BOD member •  Pay outside firm to do valuation


Process Overview •  AICPA Prescribed Methodology for Deferred Compensation

Programs outlined in the practice aid •  Required every twelve months or sooner if there is a material

change in the business •  Consistent with IRS Revenue Rule 59-60, must evaluate internal

and external factors

Internal Factors •  Milestones achieved •  Management experience / track record •  Workforce skill •  Existence of intellectual property •  Advantageous business relationships •  Financial performance, etc.

External Factors •  State of the industry / economy •  Competitive landscape •  Industry attractiveness •  Barriers to entry, etc.

Channing Hamlet Managing Director, Cabrillo Advisors

Three Step Process

Common Enterprise Value Approaches

•  Market Approach: Review of publicly-traded companies and valuations for recent private transactions for similar businesses

•  Income Approach: Based on the present value of anticipated future cash flows (aka Discounted Cash Flow)

•  Asset Approach: Value of both tangible and intangible assets


Step 1: Business Enterprise

Value

Step 2: Allocate Among Equity Classes

Step 3: Consider Discounts

Three Step Process

AICPA Prescribed Methods

•  Option Pricing Method: Black-Scholes model to allocate the Company's value between the different classes of equity

•  Probability Weighted Expected Return Method: Based upon an analysis of scenarios (IPO, acquisition, bankruptcy, etc.)

•  The Current-Value Method: The Common Stock equity value is determined by subtracting the liquidation preference of the Preferred Stock



Value



Three Step Process

Discounts

•  Lack of Control: Account for the lack of control. Appropriate in the event that the Enterprise Value is conducted on a control interest basis.

•  Lack of Marketability: Account for the lack of marketability of the subject stock, based on a number of factors (such as expected time to liquidity and transfer restrictions)



Value



Information Requirements Generally try to work with information available. Following are the high level information requirements:

•  Financial Data o  Historical financial statements o  Projected financial statements

•  Capital Structure o  Cap table, listing all classes of securities including options, warrants, etc… o  Articles of Incorporation describing the terms and rights of each class of stock o  Terms of debt and convertible debt

•  Business Information o  Business plan or investor pitch materials o  Risks and opportunities o  Research and analysis of competition

•  Other Information o  History of all transactions in company securities o  Disclosure of pending transactions


Observations and Pitfalls


•  The "rule of thumb" of taking the Preferred Price and dividing it by 8 or 10 is no longer an acceptable or appropriate method

•  There are a number of future audiences that need to be considered (all of whom will have the benefit of hindsight) o  IRS: While the IRS has not yet challenged valuations, it has to be a primary factor in

evaluating a valuation o  CPA Firm: Can serve as an input for financial reporting (stock compensation expenses) o  Acquirer: Will require you to represent compliance with tax issues including 409a and may

review valuations to verify o  SEC: In the event your company pursues an IPO, the SEC will carefully review valuations

•  409A is important since it is tough to correct

mistakes made with option grants

409A Auditor's Perspective •  Why is this topic relevant to your auditor?

o  Impact on financial statements to be audited o  Impact of cheap stock reviews in initial public offering process

•  Most common myth/rule of thumb (10:1 ratio)

o  Investor interest in value of options o  Regulator interest in value of options

•  When should I have a valuation performed (and how often)?

o  Pre-revenue, post-revenue? o  Annual, quarterly or more frequently? o  In conjunction with a round of investment or financing?

Ed Sullivan Audit Partner, KPMG

409A Auditor's Perspective

Ed Sullivan Audit Partner, KPMG

•  Who should I hire to perform the valuation? o  Sole practitioner o  Small firm o  Large firm o  Internal Resource

•  When should I get my auditor involved? o  Initial planning o  Upon issuance of a draft report o  After issuance of final report o  Impact on Board approvals o  Impact of completion of financial statement audits

Closing Thoughts

Three Perspectives on 409A Valuations: § Legal Adviser § Valuation Provider § Audit Firm

Questions

Answers from Panelists

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straight talk on 409a valuations: getting it right the first time

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