know your valuation for equity compensation (and avoid the perils of 409a)
DESCRIPTION
If you are planning to offer anyone stock options - including employees and consultants - then you NEED to understand how to value your company correctly. If you run afoul of the 409A rules, you and your employees could have a very unpleasant tax surprise. In this workshop, we will cover: The difference between valuation for 409A and valuation for raising money The difference between ISOs and non-ISOs General valuation concepts and approaches that the IRS has outlined, especially as they apply to early-stage companies If and when you need to engage an outside expert to assist with a valuationTRANSCRIPT
MEMBER OF PKF NORTH AMERICA, AN ASSOCIATION OF LEGALLY INDEPENDENT FIRMS © 2010 Wolf & Company, P.C.
Know Your Valuation For Equity Compensation (and Avoid the Perils of 409A)
Exclusively for
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Introductions
• Scott Goodwin – Wolf & Company, PC– Member of the Firm– Technology Services Team Leader– TCN board of directors and program committee chair
• Alicia Amaral – Scalar Analytics– Managing Director, Boston office– Instructor of Entrepreneurial Finance, Tufts University– CPA and Certified Valuation Analyst, CVA– Past CFO
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Who is Wolf & Company?
• Boston based, regionally focused
• 18 owners and 190 professionals in three offices
• Niche focused– Technology Services Team
• Provide our clients with direct access to owner-level expertise
• Ability to grow with you
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Scalar Analytics
• 600+ valuations per year • Majority of clients backed by venture capital firms
and angel groups• Clients in virtually every industry• Work with all of the “big 4” audit firms and
countless regional firms
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Agenda
• Overview of stock compensation plans• Overview of IRC Section 409A• The who, what, why and how of valuations• Q&A
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Stock Compensation Overview
• Common forms of stock compensation– Founders shares– Options– Restricted stock
• Tax treatment
• Advantages and disadvantages
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Overview of IRC Section 409A
• What is it?• How does it impact stock compensation?• What is the worst that could happen?• What do you as an entrepreneur need to know to
stay out of trouble?• What are best practices at various stages of
development?
Standard of Value
• Fair Market Value– Assumes hypothetical buyer– This is standard for 409A (per IRS)
• Investment Value– Assumes strategic buyer
409A ≠ VC investment
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Investment Valuation for Start-Ups
• Discounted Cash Flow???• Berkus• Bill Payne Method• Risk Factor Simulation• Venture Capital Method
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David Berkus Method
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$500k for each• Good idea• Prototype
• Quality Team• Quality Board• Initial Sale
Value $0 to $2.5 Million
Bill Payne Method
FactorManagementSize of Opportunity/MarketProduct/ServiceSales ChannelsStage of BusinessOther
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Weight30%25%10%10%10%15%
100%
Rating 100 = Average, 100+ = above average, 100- = belowMultiply result by $1.75M
Bill Payne Method Example
FactorManagementSize of OpportunityProduct/ServiceSales ChannelsStage of BusinessOther
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Weight30%25%10%10%10%15%
100%
Rating125115110
70125
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Total37.5028.7511.00
7.0012.5012.00
108.75
Value = $1.75M * 108.75 = $1,903,125
Risk Factor Simulation Method
Risk FactorManagementStageFunding RiskRegulatoryManufacturingSales & MktgCompetitionTechnologyLitigationReputationalExit
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Risk Factor+$500k+$250k-$250k
0+$250k-$500k+$250k+$250k
$0-$250k+$250k
$250k
ValuationBase $1.75MRisk 250kValue $2.0M
Venture Capital Method
Determine the• Investor’s required rate of return (ROI),
and• Terminal Value (TV)
Work backwards to get valuation (Post $)
TV can be either exit or next round14
VC Method Example
• TV based on estimated revenues and/or Net Income in terminal year
• Example: – Estimated revenue in Year 5 is $40M– Average multiplier for industry = 2– So your estimated value of the company at the end of year 5
, or TV = $40M * 2 = $80M
*Note: Can also estimate TV based on Net Income and apply average P/E multiples
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VC Method Example
• ROI• Say I sell an investment for $100M that I
purchased for $20M. What’s my ROI?• Answer: $100M / 20M = 5x• Same as TV/Post$ = ROI• To solve for Post$: Post$ = TV/ROI
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VC Method Example
• Say in our example that investor needs a 20X ROI• Post $ = TV/ROI• Post $ = $80M / 20• Post $ = $4,000,000
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Three Valuation Methods
Formal Valuation Methods 409A
1. Asset Approach
2. Market Approach
3. Income Approach
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2. Market Approach
a) Recent securities transactions methodb) Comparable (guideline) public company methodc) Comparable transaction methodd) Industry-specific multiples
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2b. Market Example: Guideline Public Company Method
Data for similar public companies in same industry• Salesforce.com, Inc.• Concur Technologies, Inc.• Kenexa Corp.• LogMeIn, Inc.• Constant Contact, Inc.
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In thousands of dollars (000) LTM Revenue LTM EBITDA NTM Revenue NTM EBITDA
Venture Co. $6,812.0 ($6,337.8) $14,380.7 ($3,166.6)
Mean Multiple 5.0x 22.1x 4.0x 19.2x
Implied Enterprise Value $33,809.2 N/A $57,270.2 N/A
Average Enterprise Value $45,539.7
Plus Cash $4,441.9
Market Value of Invested Capital $49,981.6
Steps in the Valuation Process
1. Take weighted average of applicable methods (asset, market or income) to come up with enterprise value
2. Allocate the enterprise value among classes of stock
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Valuation
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Step 1 – Determine enterprise value using weighted average of applicable methods (Asset, Market and Income)
Fair Market Value of Venture Co. as of September 30, 2012 Market Value of Method Weighted
In actual dollars Invested Capital Weighting Value
Adj. Book Value of Assets (Cost) $5,914,647 0.0% $0
Invested Capital (Cost) $22,182,037 0.0% $0
Recent Securities Transaction Backsolve (Market) $42,932,012 25.0% $10,733,003
Public Comps Valuation (Market) $49,981,604 25.0% $12,495,401
Acquisition Comps Valuation (Market) $55,094,153 25.0% $13,773,538
Discounted Cash Flow Valuation (Income) $44,606,522 25.0% $11,151,631
Weighted Market Value of Invested Capital $48,153,573
Less Debt ($1,750,000)
Weighted Equity Value $46,403,573
Step 2: Allocation
• Simply means “who gets what” in the event of an exit
• Common shareholders get paid after preferred
Remember that the purpose of 409A is to value common stock
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Option Value Analysis Option 1 Option 2 Option 3 Option 4 Option 5 Option 6 Option 7 Option 8 Option 9 Option 10
Definition: Before this breakpoint… Series C
liquidation
preference
Series B & A
liquidation preference
Common
participates
Allocated options
exercise
Series A converts to
common
Common
Warrants
exercise
Unallocated
options
participate in
value
Series B converts
to common
Series C reaches
3.0x
participation cap
Series C converts
into Common
stock
Break Points $0 $20,771,210 $22,182,037 $25,812,886 $27,793,293 $28,582,104 $39,428,548 $56,429,660 $301,546,405 $421,162,792 Infinity
Current Equity Value (Price) $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573
Exercise $0 $20,771,210 $22,182,037 $25,812,886 $27,793,293 $28,582,104 $39,428,548 $56,429,660 $301,546,405 $421,162,792 Infinity
Riskfree Rate 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31%
Maturity (in years) 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0
Volatility 54% 54% 54% 54% 54% 54% 54% 54% 54% 54% 54%
d1 28.942 1.333 1.264 1.103 1.025 0.995 0.654 0.275 (1.501) (1.855) 0.000
d2 27.998 0.389 0.320 0.159 0.081 0.051 (0.290) (0.669) (2.445) (2.799) 0.000
Call Option Value: $46,403,573 $28,763,403 $27,871,048 $25,735,075 $24,660,647 $24,249,313 $19,421,999 $14,152,891 $929,712 $405,738 $0
Incremental Option Value $17,640,170 $892,355 $2,135,972 $1,074,429 $411,334 $4,827,313 $5,269,108 $13,223,179 $523,975 $405,738
Option Value of Security Option 1 Option 2 Option 3 Option 4 Option 5 Option 6 Option 7 Option 8 Option 9 Option 10
Series C $17,640,170 $0 $488,775 $204,543 $67,632 $795,364 $799,205 $1,933,391 $0 $60,031
Series B $0 $697,195 $0 $0 $0 $0 $0 $414,235 $19,010 $12,542
Series A $0 $195,160 $0 $0 $40,566 $229,734 $230,844 $566,020 $26,281 $17,340
Common $0 $0 $1,647,197 $689,319 $227,924 $2,680,416 $2,693,361 $6,604,011 $306,632 $202,309
Allocated $0 $0 $0 $180,567 $59,705 $702,136 $705,527 $1,729,925 $80,322 $52,995
A Warrants $0 $0 $0 $0 $15,507 $87,821 $88,245 $216,372 $10,046 $6,628
Common Warrants $0 $0 $0 $0 $0 $331,842 $307,524 $754,035 $35,011 $23,099
Unallocated $0 $0 $0 $0 $0 $0 $444,402 $1,005,190 $46,672 $30,793
Total $17,640,170 $892,355 $2,135,972 $1,074,429 $411,334 $4,827,313 $5,269,108 $13,223,179 $523,975 $405,738
Total Option Value Option Value Total Shares
Share Value
(Marketable)
Marketability
Discount
Share Value (Non-
Marketable)
Series C $21,989,112 5,934,632 $3.705 0.0% $3.705
Series B $1,142,982 1,239,906 $0.922 0.0% $0.922
Series A $1,305,945 1,714,171 $0.762 0.0% $0.762
Common $15,051,167 20,000,000 $0.753 35.7% $0.484
Allocated $3,511,178 5,239,012 $0.670 35.7% $0.431
A Warrants $424,620 655,276 $0.648 35.7% $0.417
Common Warrants $1,451,511 2,283,567 $0.636 35.7% $0.409
Unallocated $1,527,057 3,044,179 $0.502 35.7% $0.323
Total $46,403,573 40,110,742
Summary
• STEP 1Enterprise Value $48,153,573Less Debt (1,750,000)Equity Value $46,403,573
• STEP 2Allocation to common $15,051,167Divided by # shares ÷ 20,000Price per share = $0.753
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Discount
• Discount for lack of marketability (DLOM) 25 – 45%
• Discount for Venture Co. = 35.7%• Price per share $0.753 less 35.7% =
$0.484 per share
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Other Points
• Value is based on a number of assumptions that have a material impact on the result– Projected cash flows– WACC– DLOM– Comparable companies
• Important to have a “DEFENDABLE VALUE” (IRS and auditors)
• Important to review report for reasonableness of assumptions. You know your business.
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QUESTIONS AND ANSWERS
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Resources
To be posted to TCN website:
• Detailed outline and PowerPoint presentation• Scalar Analytics – white paper, “Section 409A – Common
Stock Valuation”