Straight Talk on 409A Valuations: Getting It Right the ... · • Why you should consider getting a...
Transcript of Straight Talk on 409A Valuations: Getting It Right the ... · • Why you should consider getting a...
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
Dave Broadwin Partner, Foley Hoag
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
Dave Broadwin Partner, Foley Hoag
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.
Dave Broadwin Partner, Foley Hoag
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.
Dave Broadwin Partner, Foley Hoag
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.
Dave Broadwin Partner, Foley Hoag
Pricing Option Grants • Guess (toast if you are wrong) • Internal valuation by a sophisticated BOD member • Pay outside firm to do valuation
Dave Broadwin Partner, Foley Hoag
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
Channing Hamlet Managing Director, Cabrillo Advisors
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
Channing Hamlet Managing Director, Cabrillo Advisors
Step 1: Business Enterprise
Value
Step 2: Allocate Among Equity Classes
Step 3: Consider Discounts
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)
Channing Hamlet Managing Director, Cabrillo Advisors
Step 1: Business Enterprise
Value
Step 2: Allocate Among Equity Classes
Step 3: Consider Discounts
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
Channing Hamlet Managing Director, Cabrillo Advisors
Observations and Pitfalls
Channing Hamlet Managing Director, Cabrillo Advisors
• 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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