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This bulletin offers an introduction to thePractice Aid titled Valuation of Privately-Held-Company Equity Securities Issued asCompensation, which was published by theAmerican Institute of Certified PublicAccountants (AICPA) earlier this year as part ofits Audit and Accounting Practice Aid Series.

The Cheap-Stock Problem

The term “cheap stock” is often used to referto the practice of granting stock or options toacquire stock at a price per share less thanthe fair value of that stock on the date ofgrant. Fair-value determinations made byprivate companies are subject to review bytheir auditors, the Internal Revenue Service,and, in connection with an initial publicoffering (IPO), the Securities and ExchangeCommission (SEC). In connection with acompany’s IPO, the SEC typically reviews acompany’s option grant activity and fair-valuedeterminations for the 12-18 month periodpreceding the filing of its registrationstatement. However, significant or unusualgrant activity outside of this period may alsoattract SEC review and comment.

Historically, the valuation of private-companysecurities for purposes of option pricing hasbeen done without generally acceptedguidelines or principles. The absence of suchguidelines or principles created anenvironment of uncertainty where privatecompanies sought to understate valuationsand regulators sought to inflate them. As aresult, many private companies have been

forced by the SEC or their independentauditors to restate financial statements andincur substantial deferred compensation orcheap-stock charges in connection with theirIPO. The objective of the AICPA Practice Aidis to identify certain principles andprocedures for option pricing that can serveas best practices or a framework in whichprivate companies and regulators can actwith greater confidence and certainty.

The AICPA Practice Aid

The Practice Aid was developed by a taskforce consisting of representatives from thebig four accounting firms, leading valuationfirms, the AICPA, corporations, academicinstitutions, and the National Venture CapitalAssociation (NVCA). Wilson Sonsini Goodrich& Rosati was the only law firm representedon the task force. Representatives of the SECand the Financial Accounting Standards Board(FASB) served as observers of the task force.

The Practice Aid outlines best practices, inthe opinion of the task force, for valuingprivate-company securities issued ascompensation. The Practice Aid is not anaccounting standard and is not approved,disapproved, or otherwise acted on by anysenior technical committee of the AICPA, theFASB, or the SEC. However, the objective ofthe Practice Aid is to help reduce the risk ofdeficiencies in option pricing decisions byidentifying and defining best practices forprivate companies to follow voluntarily. Acomplete copy of the Practice Aid is available

for purchase at a price of $65.00 (AICPAmembers) or $81.25 (non-members) atwww.aicpa.org/members/div/acctstd/vpes.asp

The Concept of Fair Value

Fair value, as defined in Statement of FinancialAccounting Standard (SFAS) 123, is theamount at which a minority common-stockinterest in a privately held enterprise could bebought or sold in a current transactionbetween willing parties, other than in a forcedor liquidation sale. The FASB has preliminarilyindicated that fair value as defined in theaccounting literature is consistent with fairmarket value as defined by the IRS.

For purposes of determining the fair value ofprivate-company securities, the Practice Aidreviews various indicators of fair value andranks them in the following order:

1. Published trading prices in activemarkets;

2. Recent arms-length cash transactionswith independent third parties; and

3. Enterprise valuations based onmarket-, income- or asset-basedmethodologies.

While published trading prices in activetrading markets provide the best evidence offair value, they are not available for privatelytraded companies. Arms-length transactionswith independent third parties for the sale ofprivate-company securities do exist.

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VALUATION OF PRIVATE-COMPANY SECURITIES ISSUED AS COMPENSATIONTHE AICPA PRACTICE AID TO OPTION PRICING

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However, such transactions are infrequentevents that rarely coincide with the relevantmeasurements date and, even when they dotake place on or around the measurementdate, they often involve a different class ofstock than the one being valued. Accordingly,the Practice Aid provides in-depth guidanceon valuing private-company securities in theabsence of published trading prices or arms-length transactions in the same class ofstock. The Practice Aid also providesguidance on allocating value among differentclasses of stock issued by the enterprise.

Hierarchy of Enterprise Valuation Methods

A central theme of the Practice Aid is that thevaluation of private-company securitiesrequires sophisticated techniques,experience, and independence. The reliabilityof a valuation depends upon experience,timing, and objectivity. Accordingly, thePractice Aid sets out the following hierarchyof valuation alternatives to be used indetermining who performs the valuation andhow often a valuation is done:

1. A contemporaneous valuation by anindependent valuation specialist;

2. A retrospective valuation by anindependent valuation specialist; and

3. A contemporaneous or retrospectivevaluation by a related valuationspecialist.

The Practice Aid strongly encourages the useof Level 1 valuations and suggests that therisk of challenge for a valuation should belowest at Level 1, provided that theassumptions and techniques used in thevaluation are reasonable. For Level 2 and 3valuations, the Practice Aid recommends thatthe party relying on such valuation provideinformation regarding the factors,assumptions, and techniques used; thereasons why a Level 1 valuation was notobtained; and, in the case of retrospectivevaluations, a reconciliation of the valuationreport findings and the value of the securitieson the reference date, such as the date of

significant option grant activity and/or thedate of a company’s IPO. For companies inthe IPO process, the Practice Aid recommendsthat this information be included in thecompany’s registration statement.

Frequency of Valuations

In order for a valuation to qualify as a Level 1valuation, it must be contemporaneous withthe relevant measurement date, such as thedate of significant option grant activity. Themeaning of contemporaneous in this contextdepends on the facts and circumstances ofthe company being valued. In general, avaluation will be consideredcontemporaneous if it is completed at oraround the measurement date and nomaterial changes to the company’s businessor value drivers have occurred between thevaluation date and the measurement date.Accordingly, the frequency of valuationsrequired to remain at Level 1 will depend onthe timing of material changes, milestones, orother developments involving the company.The Practice Aid recommends that companiesobtain a series of third-party valuations, withthe interval between such valuations beinginfluenced by factors set forth in the PracticeAid, including:

• The timing of significant events ormilestones that are expected to affectthe company’s value;

• The issuance of equity securities,including financing transactions andsignificant option grants; and

• The company’s stage of development.

Companies seeking to obtain a series ofvaluations may wish to retain an independentvaluation specialist to perform suchvaluations at pre-negotiated prices for thefirst valuation and each subsequent valuation.Whether a subsequent valuation is simply anupdate or an entirely new and completevaluation will depend on the nature ofchanges to the company’s business and valuedrivers between the two valuation dates.

Fair Value of the Enterprise

In the absence of quoted market prices orrecent arms-length transactions in acompany’s stock, the valuation of companysecurities generally begins with the valuationof the enterprise as a whole. Valuationspecialists typically consider more than onemethod in determining enterprise value.These methods include:

• The income approach, which measuresvalue based on the expected presentvalue of the company’s projectedfuture cash flows;

• The market approach, which measuresvalue based on the value of similarcompanies that are publicly traded orhave recently been acquired inpublicly disclosed transactions; and

• The cost approach, which measuresvalue by restating the assets andliabilities of the enterprise at theircurrent fair market value.

The Practice Aid discusses the suitability ofeach of these methods at various stages ofan enterprise’s development, with the costapproach applied more often during earlierstages when the information required toapply the income or market approaches maynot be available.

Marketability Discounts

The Practice Aid discusses the application ofmarketability discounts when valuing private-company securities based in part on dataregarding publicly traded companies. Whilethe Practice Aid recognizes that a marketabilitydiscount may be appropriate, it recommendsthe valuation specialist take a number offactors into account in determining the size ofthe marketability discount. The Practice Aidsuggests that the marketability discount bereduced for certain factors including:

• Lower perceived risk and volatilityassociated with the enterprise;

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• Contractual arrangements thatincrease liquidity, such as put rightsand registration rights; the absence ofcontractual arrangements that limitliquidity, such as transfer restrictions,drag-along rights, and rights of firstrefusal; and

• Strong and recognizable indicators ofenterprise value that lead to greatercertainty about the enterprise’s valueand the value of its stock.

Allocation of Enterprise Value

Once a company’s enterprise value has beendetermined, that value must be allocatedamong its various classes of equity securities.The Practice Aid recognizes that there aresignificant differences between common andpreferred stock that affect their respectivevalues. The Practice Aid also recognizes thatthat some rights and preferences, such asliquidation preferences, are easier to measureand value than others, such as anti-dilutionrights and voting rights. In addition, itspecifically rejects the use of “rules ofthumbs” in allocating value between preferredand common stock. An example of such a ruleof thumb is the pricing of common stock at 10percent of the preferred stock price.

An enterprise’s value must be allocatedamong its classes of stock based on thedifferences in rights associated with suchstock, taking into account the circumstancesand prospects of the enterprise and thelikelihood that such special rights andpreferences will be triggered. The PracticeAid describes three enterprise valueallocation methods and the pros and cons ofeach. These methods are:

• the current value method;

• the option pricing method; and

• the probability-weighted expectedreturn method.

These methods are not the only allocationmethods that may be used. The Practice Aid

simply suggests that the method used shouldtake into account the stage of the company’sdevelopment and the applicability of theparticular method.

The Current Value Method

The current value method assumes that theenterprise is immediately liquidated with theproceeds available for distribution beingequal to the overall enterprise value. Thismethod then allocates the enterprise value inaccordance with the liquidation preferenceprovisions of the preferred stock set forth inthe company’s charter documents. The fairvalue of each class of stock is thendetermined based on the return per sharepayable to such class in the assumedliquidation.

The key advantage of the current valuemethod is its ease of implementation. Thismethod also has a certain mathematicalelegance and simplicity that has resonatedwith many private-company auditors.However, the principal limitation of thismethod is that the immediate liquidation ofthe company is not, in most cases, a realisticassumption. As a result, the Practice Aidlimits the application of this method tosituations in which a liquidation or acquisitiontransaction is imminent or the company is anearly-stage enterprise where no materialprogress has been made on its business planand there is no reasonable basis forestimating the timing and amount of anycommon equity return that might be realizedin the future—which makes the applicationof the other methods described belowdifficult, if not impossible.

The Option Pricing Method

The option pricing method of allocatingenterprise value among common stock andpreferred stock views each class of stock as acall option on all or part of the enterprise’svalue. This method utilizes option pricingmodels such as Black-Scholes to price eachcall option.

The key advantage of this approach is that itconsiders the impact of liquidationpreferences over a range of future liquidationvalues and dates. However, this method iscomplicated to implement and sensitive tokey assumptions. In addition, since privatecompanies are being valued, the lack oftrading history makes the volatilityassumption used in the valuation formula verysubjective. Overall, the task force concludedthat this approach is most applicable to mid-to later-stage companies that have a widerange of possible future outcomes ahead ofthem.

The Probability-Weighted ExpectedReturn Method

The probability-weighted expected returnmethod is the most theoretically pureapproach to allocating enterprise value, but, itis also one of the most difficult methods toimplement. Under this method, the value ofthe enterprise is determined at each point ina range of future outcomes and dates.Typical future outcomes for a companyinclude liquidation, acquisition, IPO, andcontinued existence as a private company. Inits simplest form, this method involves thefollowing steps:

1. Determine the value of the enterpriseat each future outcome and the mostlikely date of each outcome;

2. At each outcome, determine theallocation among common andpreferred stock based on theliquidation preferences of each;

3. Discount the per share returns topresent value using a risk-adjusteddiscount rate;

4. Assign probabilities to each outcome;and

5. Multiply the probability of eachoutcome by the expected return pershare for that outcome to determinethe probability-weighted expectedreturn for each class of stock.

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The above outline uses a single future dateand valuation for each of the outcomes.More complex forms of this approach use arange of enterprise values and a range ofpossible dates for each outcome. This isdone using statistical models and volatilityestimates similar to the Black-Scholesmethod. While such models exist and are inuse on a proprietary basis, they tend to addcomplexity and lack transparency in theirapplication.

The probability-weighted expected returnmethod is conceptually strong and forward-looking. It considers the rights of each classat times when those rights are expected to beapplied and is not as sensitive as the othertwo methods to a change in a singleassumption. However, this method relies ona very large number of assumptions. This

approach is also complicated to implementand the estimates of probabilities, dates, andvalues are difficult to support.

The Practice Aid indicates that there is nogeneric or textbook version of this model(such as the Black-Scholes approach to theoption pricing method). Instead, it suggeststhat valuation specialists develop their ownframeworks for applying this model.

Conclusion

As indicated above, the Practice Aid is not anaccounting standard, and is not approved,disapproved, or otherwise acted on by anysenior technical committee of the AICPA, theFASB, or the SEC. The objective of thePractice Aid is to identify and define bestpractices for private companies to follow

voluntarily, based on the task force’s beliefthat auditors and regulators may give greaterweight to results obtained using suchpractices, properly applied. Since the releaseof the Practice Aid, accounting firms havebegun to rely on it as a tool for reviewingoption pricing decisions of their private-company clients in connection with year-endaudits. In addition, recent experience in alimited number of IPO filings does suggestthat members of the SEC staff are taking therecommendations of the Practice Aid intoaccount in their review of registrationstatements. However, more time is needed todetermine whether the Practice Aid will fulfillits objectives of providing a framework forvaluing private-company securities andbringing greater predictability and certainty tooption pricing decisions.

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This bulletin is intended only as general information about the matters discussed, and should not be construed as legal advice. For moreinformation about these matters, please contact Robert Latta, Asaf Kharal, or your WSGR partner.

Wilson Sonsini Goodrich & Rosati,Professional Corporation

650 Page Mill RoadPalo Alto, CA 94304-1050

650-493-9300650-493-6811 (Fax)

www.wsgr.com©2004

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