rick's presentation

Executive Compensation in the Post-409A Era

Determining Fair Market Value for Granting Options and SARs

January 16, 2008

Denver Software Club


• IRS Guidance – reasonable application of a reasonable valuation method

• Considers:– Value of tangible and intangible assets

– Present value of future cash flows

– Market value of stock of similar companies

– Other relevant factors such as discounts (lack of control/marketability/liquidity)


Unreasonable to use – a previously calculated value that fails to

reflect all material information

– a calculation that is more than 12 months old

• Management prepared analysis:– Company is less than 10 years old

– A liquidity event is not expected in 12 months

– Put/call options to not exist on stock


• Differences with other appraisal assignments– Assignment does not stop at enterprise

value– Capital structures is a major

consideration


• Value of the common stock

Option Pricing Model

Allocation of Value - Option

PricingModel

Residual is CommonStock Value

PriceUsedFor

Options

FinancingRounds,DCF or Market Multiple

Benchmarking/ Put Option

Analysis

1

34

2

5

Common Stock

Preferred Stock

Options and Warrants

Marketability Premium

Common Stock

1) Enterprise Value




PricingModel


PriceUsedFor

Options



Analysis

1

34

2

5

Common Stock

Preferred Stock



Common Stock

1) Enterprise Value

• Fair Market Value of Enterprise– Revenue Ruling 59-60

• Nature or business since inception

• Economic outlook for industry

• Book value of stock

• Earnings capacity

• Dividends

• Existence of goodwill and intangible value

• Sale of the stock and size of block to be valued

• Market prices of similar companies

1) Enterprise Value

• Valuation Approaches– Asset based approaches– Income based approaches– Market based approaches

2) Complex Capital – Allocation of Value




PricingModel


PriceUsedFor

Options



Analysis

1

34

2

5

Common Stock

Preferred Stock



Common Stock


• AICPA Practice Aid “Valuation of Privately Held Company Equity Securities Issued as Compensation”– Current Value Method– Probability Weighted Expected Return

Method (PWERM)– Option Pricing Methods


• Current Value Method– Considers what preferred and common

shareholders receive if the current value is liquidated today for cash


• Probability Weighted Expected Return Method– Projects out various liquidity events in

the future and assigns probabilities to different events


• Option Pricing Methods– Black-Scholes Mertons Model– Lattice Models (Binomials)– Simulation Models


• Black-Scholes Merton Model– Call Price = S e-q N(d1) - X e-rt N(d2)

• d1 = [ln(S/X) + (r – q + ½)t]/(t½)• d2 = d1 – t½

– Stock price (S)– Strike Price (X)– Volatility ()– Interest Rate (r)– Time to Expiration (t)– Dividend Yield (q)


• BSM Application to Complex Capital– Common and preferred stock share in value

above liquidation preference– Value of common stock is share of call option

with liquidation preference as “strike” price– Static assumptions as to number of

outstanding shares and time to liquidity event (time to expiration)

– Allocates value to common and preferred stock – excludes potential dilution from outstanding options and warrants


• Lattice Models – Binomial – Simple 1 period Binomial

Stock price now

Price in one year

$50

$60

$40Assume: rf = 5%

Calculate a call option with a strikeprice of $50


• Lattice Models – Binomial– Compute payoffs:

• Upstate ($60): option payoff is $10• Downstate ($40): option payoff is $0

– Determine portfolio of 1 share of stock and (h) call options

• Upstate: $60 + $10 x (h)• Downstate: $40 + $0 x (h)• h = -2 (long 1 share, short 2 options)


• Lattice Models – Binomial– Determine payoff to hedged portfolio:

• $60 + $10 (-2) = $40 + $0(-2) = $40

– Present value of portfolio:• PV = $40/1.05 = $38.10

– Separate current value into parts• $50 current price – $38.10 portfolio =

revenue received for sale of 2 call options• $11.90/2 call options = $5.95 per option


• Lattice Models – Binomial– Backward induction

Option price Payoff

$10

$0Assume: rf = 5%

$5.85


4 periods,3 months each

52.5050

45

50

3 months 3 months

47.50

57.5055

60

55

50

45

40

42.50

47.50

3 months 3 months

52.50

Treat each node of the tree as a one-stage binomial problem and work your way from the back of the tree to the front to find the call option’s value


4.563.24

0.0

1.91

3 months 3 months

0.0

8.11

6.21

10

5

0

0

0

0.0

1.16

3 months 3 months

3.11

In the limit, as we shorten the time interval between moves and reduce the stock movement in each interval, we approach the Black Scholes option pricing model


• Simulation Models– Uses “random” walks to determine

“expected” returns for classes of stock– Numerous (10,000 +) iterations are

run and statistics are analyzed


• Simulation Models - Distribution Distribution for Discounted Payout per Share

(control interest basis)Series A Preferred Stock

Mean = 125.3151

X <=61.355%

X <=211.3795%

0.00%

0.22%

0.44%

0.67%

0.89%

1.11%

1.33%

1.56%

1.78%

2.00%

$0 $50 $100 $150 $200 $250 $300 $350 $400 $450 $500


• Simulation Models - Distribution Distribution for Discounted Payout per Share

(non-marketable, minority interest basis)Common Stock

Mean = 16.83566

X <=05%

X <=68.0695%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

$0 $50 $100 $150 $200 $250 $300 $350 $400 $450 $500

3) Illiquidity/Minority Discounts




PricingModel


PriceUsedFor

Options



Analysis

1

34

2

5

Common Stock

Preferred Stock



Common Stock

3) Illiquidity/Minority Discounts

• Minority Interest Discount– Lack of prerogatives of control

• Lack of Marketability/Illiquidity– No ready market for shares– Potential other restrictions on sale

4) Value of Common Stock

• After allocation of value and application of discounts, remaining value is common stock

rick's presentation

Business

enterprise value value

options value

era value

value of tangible

calculated value

common stock value price

separate current value

present value of portfolio