Section I INTRODUCTION TO IRC 409A VALUATIONS · (409A), Family Limited Partnerships (FLPs),...

Section IINTRODUCTION TO IRC 409A

VALUATIONS

Jeff Faust, AVA and Ben Towne, CPA/ABV/CFF, CVABerger Lewis Accountancy Corporation

55 Almaden Blvd.Suite 600

San Jose, CA 95113-1605(408) 494-1200

Email: [email protected]; [email protected]

1

Introduction to 409A Valuation

Oakland, CA

November 18, 2010

By Jeff Faust and Ben Towne

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Agenda• Introduction

• Brief History of 409A

• 409A in General

• Valuation Challenges

• Capital Structure Complications

• Allocation Approaches

• Auditor Issues

• Risk Exposure

• Questions

3

Introduction

Jeff Faust• Over 20 years in finance, serial entrepreneur.

• 15 years in Business Valuations.

• Over 65 different industries.

• All sizes and stages of development.

• Employee Stock Ownership Plans (ESOPs), Stock Options(409A), Family Limited Partnerships (FLPs), Buy-SellAgreements, Estate/Gift Taxes, Mergers/Acquisitions andTransactions, Litigation Support.

• Testified in front of the Department of Labor and in severalSuperior Courts in the Bay Area.

• Accredited Valuation Analyst (AVA) with the NationalAssociation of Certified Valuation Analysts (NACVA).

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Introduction

Ben Towne• CPA with valuation credentials from the AICPA and NACVA.

• 10 years with Berger Lewis; 4 in tax and audit, 6 years inBusiness Valuations.

• Large real-estate holding entities, high-tech start-ups withcomplex capital structures, professional service companies,and manufacturing and design companies.

• President of the Silicon Valley San Jose chapter of theCalifornia Society of CPAs, and is on the state council.

• Guest lecturer at San Jose State University and the KeiretsuForum Entrepreneur Academy.

• Recently published in the Value Examiner “Using Put OptionAnalysis on Real Estate Holding Entities to Estimate a Discountfor Lack of Marketability.”

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Introduction

Audience Poll – Experience Level?• BV Novice

• Novice to 409A

• Limited Exposure to 409A

• Experience w/ 409A

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History of 409A

• Proposed Regs. in October 2004

• All options granted or unvested after 1/1/05

• Officially took effect 1/1/09

– Options granted between 2005 and 2009 are not considered toviolate 409A as long as there was good faith effort to comply withthe regulations and guidance notices.

• If options violate 409A, option recipients get taxed andpenalized.

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409A in General

• 409A is about deferred comp, why are stock option included?

• ISO, NQSO, SARs

• How is FMV determined?

# 3 Methods of Valuation

1. a valuation based upon certain types of formulas

2. a valuation of illiquid stock of a start up company byexperienced personnel (regs vs final)

3. an appraisal by an independent appraiser

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409A in General

• No matter who does it…

“Reasonable Valuation Methods, Reasonably Applied.”

• 2 Step Process:

1) Determine Fair Market Value

2) Allocate FMV among the various classes of securities

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409A in General

Factors that the IRS states should be considered in thevaluation in order for the valuation method to be reasonableinclude:

•the value of tangible and intangible assets of the corporation;

•the present value of future cash-flows;

•the market value of stock or equity interests in similarcorporations

•other relevant factors, such as control premiums or discountsfor lack of marketability

•The value must be determined taking into consideration allavailable information material to the value of the corporation,and must be calculated as of a date that is within 12 monthsof the date for which the valuation is being used.

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Valuation Methods

Some of the basic valuation approaches:

•Income Approach ––Discounted future earnings only, No single period capitalization

–Beware projections – how to substantiate

–Effect on discounts – include control (or not?), include illiquidity (ornot?)

•Market Approach ––Guideline Publics (basically a must – volatility, exit multiples)

–Guideline M&A (exit multiples in DCF and PWERM)

–Previous / contemporaneous round of financing

•Asset Approach ––Very early stage or liquidating

– Often leads to a “cash burn” method

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Valuation Challenges

Before we talk about allocation, we wanted to talk about someof the challenges that arise when performing the valuationstep:

•Pre-revenue

•No recent rounds

•Strategic rounds

•Hockey stick projections

•Discount rate levels

•Lingering “knowledge” and Rules of Thumb (10% ofPreferred)

•Misunderstanding of deal terms or their effects

•Bridge financing

•Differing voting rights

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Allocation Approaches

A company’s capital structure drives the need for anallocation approach:

•If a simple structure (common stock only), value divided byshares outstanding.

•If a complex structure (common and preferred stock), thevalue needs to be allocated among the various classes ofsecurities

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Capital Structure Complications• Common Stock:

– Founder Stock

– Restricted Stock

– General Common Stock

• Debt:– Non-Convertible/Convertible

• Preferred Stock:– Non-Convertible/Convertible

– Non-Participating/Participating

• Options

• Warrants

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Different equity features yield differing results…

Preferred A $5,000,000; 20 mil shares

Preferred B $3,000,000; 7.5 mil shares

Common 10 mil shares

Scenarios:

1. 100% pro rata;

2. Each Preferred A share can be converted into 1 commonshare;

3. Preferred A can be converted into common & participates up to$0.75;

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Scenario 1 – Pro Rata

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Scenario 2 – Series A Converts

Cap. Structure Summary:

Ex./Purch. Liq. Preference Face Value/ Shares Ex./Conversion Common % Total

Price Multiple Preference Outstanding Multiple (5) Stock Equiv. CSE

Series A 0.250$ 1.0 5,000,000$ 20,000,000 1.00 20,000,000 66.7%

Series B 0.400$ 1.0 3,000,000$ 7,500,000 1.00 7,500,000 25.0%

Common 10,000,000 10,000,000 33.3%Final Breakpoint

Total 8,000,000$ 37,500,000 30,000,000 100.0%

Security

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Scenario 2 – Series A Converts

Price Per Share Summary:

Notice that the allocation changes with Common dropping and A having apremium over common

Total Shares Value

Value Summary Value Outstanding per Share

Series A $3,481,832 20,000,000 $ 0.17

Series B $2,169,789 7,500,000 $ 0.29

Common $1,348,379 10,000,000 $ 0.13

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Scenario 3 –A Converts & Participates

Cap. Structure Summary:Ex./Purch. Partic. Max. Per Liq. Pref. Face Value/ Total Shares Ex./Convers. Common % Total

Price Cap Share Multiple Preference Pref./Partic. Outstanding Multiple (5) Stock Equiv. CSE

Series A 0.250$ 3.0 0.75$ 1.0 5,000,000$ 15,000,000$ 20,000,000 1.00 20,000,000 66.7%

Series B 0.400$ 1.0 0.40$ 1.0 3,000,000$ 3,000,000$ 7,500,000 1.00 7,500,000 25.0%


Total 8,000,000$ 18,000,000$ 37,500,000 30,000,000 100.0%

Security

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Scenario 3 –A Converts & Participates

Price Per Share Summary:

Notice that the Common drops even further, with the difference beingallocated to Preferred A

Shares Value Value

Value Summary Value Outstanding per Share

Series A $3,753,488 20,000,000 $ 0.19

Series B $2,169,789 7,500,000 $ 0.29

Common $1,076,722 10,000,000 $ 0.11

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AICPA Practice Aid• Valuation of Privately-Held-Company Equity Securities Issued

as Compensation, 2004 (currently under revision)

• Extremely important in 409A Valuations

• Know what it says but also what is does not say!

• Outlines 3 methods of allocation:

1. Current Value Method (CVM)

2. Option Pricing Method (OPM)

3. Probability-Weighted Expected Return Method (PWERM)

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Current Value Method (CVM)• The equity value is reduced by the senior claims of preferred

shares with the remaining balance allocated to commonshares.

• Like the old “waterfall” analysis.

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Current Value Method (CVM)

Weighted Average of Selected Methods $25,049,115

plus: Cash received from exercise of options and warrants $40,000

less: Liquidation Preference of Preferred Stock $20,761,983

$4,327,132

Divided By:

Shares attributable to remaining allocation 36,060,000

Equals:

Unrounded Price Per Share $0.1199981

Rounded Price Per Share $0.12

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Option Pricing Method (OPM)• Each class of stock is modeled as a call option with a distinct

claim on the enterprise value of the company.

• Exercise prices are based on the liquidation preferences andconversion value of the securities.

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Option Pricing Method (OPM)• Black-Scholes

C0 = [S0 * N (d1)] – [X * e-Rf*T * N (d2)]

C0 = Value of the call option

S0 = Asset price

N ( ) = Cumulative normal probability of value in parentheses

X = Exercise price

Rf = Continuously compounded risk-free rate

T = Time to maturity

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Option Pricing Method (OPM)• Difficulties:

1. Volatility (Peer Group)

2. Pricing Term

– Is it to liquidity?

– Is it to another funding round?

3. Consistency w/ ASC 718 (fka FAS 123R)

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Option Pricing Method (OPM)• Five Step Process:

1. Analysis of Capitalization Table

2. OPM Assumptions (Black-Scholes Assumptions)

3. Calculation of Breakpoints

4. Black-Scholes Calculation of Tranche Values

5. Allocating Tranche Values

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Option Pricing Method (OPM)• Step 1 – Analysis of Capitalization Table

Ex./Purch. Liq. Preference Face Value/ Shares Ex./Conversion Common % Total

Price Multiple Preference Outstanding Multiple (5) Stock Equiv. CSE

Series 1 0.32308$ 1.0 1,025,000$ 3,172,619 1.00 3,172,619 37.9%


Total 1,025,000$ 8,374,619 8,374,619 100.0%

Security

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Option Pricing Method (OPM)• Step 2 – OPM Assumptions

Equity Value 1,711,505$

Dividend Yield 0.0%

Risk-Free Rate 0.25%

Volatility (3) 44.9%

Time (in years) (4) 1.0

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Option Pricing Method (OPM)• Step 3 – Calculation of Breakpoints

Break Point # Dollar Amount

1 Liquidation Preferences - Series 1 Preferred Shares 1,025,000$

2 Conversion of Series 1 Preferred Shares 2,705,646$

Basis for Calculation

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Option Pricing Method (OPM)• Step 4 – Calculation of Tranche Value

Breakpoint Breakpoint Breakpoint

Black-Scholes Inputs 1 2 3 Total Value

Equity Value 1,711,505$ 1,711,505$ 1,711,505$

Maximum/Strike Price 1,025,000$ 2,705,646$

Expected Term 1.00 1.00 1.00

Volatility 44.9% 44.9% 44.9%

Rf Rate - Cont. Compounding 0.25% 0.25% 0.25%

Dividend Yield - Cont. Compounding 0.0% 0.0% 0.0%

Call Option Value 725,612$ 77,131$ -$

Incremental Option Value (Tranche) 985,892$ 648,481$ 77,131$ 1,711,505$

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Option Pricing Method (OPM)• Step 5 – Allocating Equity Value

Tranche Tranche Tranche Total Shares Value

Value Summary 1 2 3 Value Outstanding per Share

Series 1 985,892$ 29,220$ 1,015,112$ 3,172,619 0.32$

Common 648,481$ 47,911$ 696,392$ 5,202,000 0.13$

Equity Value per Tranche 985,892$ 648,481$ 77,131$ 1,711,504$ 8,374,619

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Option Pricing Method (OPM)

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Probability-Weighted Expected Return Method (PWERM)

• Estimates values for several likely liquidity scenarios (or lackthereof):

1. IPO

2. Acquisition

3. Dissolution

4. Private (no exit)

• The value of the common stock is determined for each scenarioat the time of each future liquidity event and discounted back tothe present using a risk-adjusted discount rate

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36


Which one should you use? (CVM, OPM or PWERM)

• CVM:1. Extremely early stage (1 & 2)

2. At a liquidity event (waterfall)

• OPM:1. Mid stage (3 & 4)

2. When CVM = $0 for common stock

3. As a “back-solve” on a recent funding round

• PWERM:1. Extremely late stage (5 & 6)

2. When an exit is within 5 years

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We suggest running all 3 at once

• Often: CVM < OPM < PWERM

• If they don’t relate, understand why!

Option Pricing MethodOPM

Market Approach Other Approach IPO Sale or Merger Dissolution Private

Methods Selected

Enterprise Values $26,528,665 $23,569,565 $25,049,115 $49,474,307 $3,300,000 $23,170,511

Timing (years) current current 5.00 0.00 5.00 5.00 current

Weighting 50% 50% 0% 30% 10% 60%

100% 100%

$25,049,115 $25,049,115 $29,074,598

Price per share $0.12 $0.43 $0.43

Discounted Cash Flow

(DCF)

Company Specific

Transaction

^ Method Selected ^

Probability-Weighted Expected Return MethodPWERM

Current Value MethodCVM

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Auditor Issues

What do they look for?

• How do they deal with judgment?

• What is their preferred method…

… of valuation?

… of allocation?

• The importance of support and good data sources!

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Auditor Issues

Challenges with the Big 4:

• Why are they so difficult?– “If it’s too high, it can’t be below FMV”

• How to (you must!) manage the process

• What if you and the auditor come to a stalemate?

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Risk Exposure (Not Adhering to 409A)

Where is the most risk exposure?

• IRS?

• Auditor?

• Other?

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Questions

Contact:

Jeff Faust, AVA

Senior Manager, Business Valuation

(408) 494 -1267

[email protected]

Ben Towne, CPA/ABV, CVA

Manager, Business Valuation

(408) 494 -1228

[email protected]

Section I INTRODUCTION TO IRC 409A VALUATIONS · (409A), Family Limited Partnerships (FLPs),...

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