www.thecapitalnetwork.org October 3, 2013 12:00pm – 2:00pm Bessemer Venture Partners, 196 Broadway, 2nd Floor Cambridge, MA 02139 If you are a CEO or a CFO of a high growth startup, it is vital to understand how to value your company correctly. Here is a quick list of questions this lunch will help you answer: Do you offer or are you planning to offer your employees stock options? Do you know the difference between ISOs and non-ISOs? Do you understand the general valuation concepts and approaches that the IRS has outlined, especially as they apply to early-stage companies? Did you know that if you run afoul of the 409A rules, your employees could have an unpleasant tax surprise and that some of that responsibility could revert back to you as the employer? Do you know if and when you need to engage an outside expert to assist with a valuation? This is a limited seat lunch to teach issues of valuation for equity compensation and ask specific questions about your company. Experts - Scott Goodwin, Wolf & Company, P.C. Alicia Amaral, Scalar Analytics

1. MEMBER OF PKF NORTH AMERICA, AN ASSOCIATION OF LEGALLY INDEPENDENT FIRMS © 2010 Wolf & Company, P.C.
Understanding
Equity
Valua2on
and
Avoiding
the
Perils
of
409A
October
3,
2013
Exclusively
for

2. 2
Introduc2ons
• ScoG
Goodwin
–
Wolf
&
Company,
PC
– Member
of
the
Firm
– Technology
Services
Team
Leader
– TCN
board
of
directors
and
program
commiGee
chair
• Alicia
Amaral
–
Scalar
Analy2cs
– Managing
Director
– Visi2ng
Professor,
Clark
University
and
TuWs
University
– CPA
and
CVA
– Past
CFO

3. 3
Who
is
Wolf
&
Company?
• Boston
based,
regionally
focused
• 19
owners
and
190
professionals
in
three
offices
• Niche
focused
– Technology
Services
Team
• Provide
our
clients
with
direct
access
to
owner-­‐level
exper2se
• Ability
to
grow
with
you

4. 4
Who
is
Scalar
Analy2cs?
• 600+
valua2ons
per
year
(50%
are
409A)
• 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

5. 5
Agenda
• Overview
of
stock
compensa2on
plans
• Overview
of
IRC
Sec2on
409A
• The
who,
what,
why
and
how
of
valua2ons
• Q&A

6. 6
Stock
Compensa2on
Overview
• Common
forms
of
stock
compensa2on
– Founders
shares
• Not
really
compensatory
• Beware
of
retroac2ve
ves2ng
provisions
• How
long
can
you
issue
them?
• Other
issues
– Founders
coming
and
going

7. 7
Stock
Compensa2on
Overview
• Common
forms
of
stock
compensa2on
– Op2on
• ISOs
–
tax
treatment
– No
tax
at
issuance
– No
tax
upon
ves2ng
– No
tax
upon
exercise
– Only
taxable
upon
sale
of
underlying
stock
– Ability
to
get
LT
cap
gain
tax
• ISO
criteria
– 8
criteria
for
being
considered
an
ISO
– Three
of
the
more
important
ones
» Issued
under
a
formal
wriGen
plan
» Exercise
price
>=
FMV
of
stock
» Can’t
be
issued
to
non-­‐employee

8. 8
Stock
Compensa2on
Overview
• Common
forms
of
stock
compensa2on
– Op2ons
• Non-­‐quals
-­‐
tax
treatment
– No
tax
at
issuance
– Taxable
income
equal
to
the
difference
between
FMV
of
the
stock
and
the
exercise
price
– Ordinary
income
» Possible
addi2onal
tax
when
stock
sold
• Factors
to
consider
when
issuing
op2ons
– Tax
advantages
– Less
immediate
dilu2on
– Keep
stock
in
few
hands
for
longer
– Difficult
to
value
and
account
for

9. 9
Stock
Compensa2on
Overview
• Common
forms
of
stock
compensa2on
– Restricted
stock
• Generally
common
stock
with
ves2ng
or
repurchase
rights
• General
tax
treatment
– Taxed
as
the
shares
vest
– Income
based
on
FV
of
shares
on
the
date
of
ves2ng
– Ordinary
income
• Factors
to
consider
– Can
be
tax
advantages
» 83(b)
elec2ons
» Start
LT
cap
gain
clock
2cking
– FV
is
easier
to
establish
for
a
share
of
stock
than
an
op2on
– BeGer
understood
by
recipients
– True
dilu2on
– End
up
with
more
shareholders
» Considera2on
when
you
want
to
pay
vendors
with
shares.
Do
you
want
them
as
shareholders?

10. 10
Overview
of
IRC
Sec2on
409A
• What
is
it?
– Part
of
the
IRC
–
issued
by
the
IRS
• No
impact
on
accoun2ng
rules
– Very
comprehensive
and
far
reaching
impact/scope
– Regula2on
governing
a
wide
array
of
non-­‐qualified
deferred
compensa2on
arrangement,
including
op2ons
• “Deferred
compensa2on”
–
legally
binding
right
to
receive
compensa2on
in
one
tax
year
that
is
or
may
be
taxable
in
a
subsequent
tax
year
– Reac2on
to
perceived
abuses
from
some
earlier
scandals
including
the
op2on
back-­‐da2ng
scandal

11. 11
Overview
of
IRC
Sec2on
409A
• How
does
it
impact
stock
compensa2on?
– Can
no
longer
safely
issue
op2ons
using
a
rule-­‐of-­‐thumb
or
simple
board
approval
– In-­‐the-­‐money
op2ons
are
imprac2cal
– 409A
is
forcing
companies
to
get
outside
valua2ons
of
their
stock
in
order
to
appropriately
set
exercise
prices
– 409A
is
forcing
companies
to
be
more
disciplined
in
their
gran2ng
process

12. 12
Overview
of
IRC
Sec2on
409A
• What
is
the
worst
that
could
happen?
– An
op2on
issuance
intended
as
an
EE
benefit
could
cause
tax
problems
for
the
recipient
– Lose
the
tax
benefits
of
ISOs
– EE’s
perspec2ve
• Ordinary
income
in
the
periods
in
which
op2ons
VEST
rather
than
when
they
are
exercised
• Regular
tax
rates
(rather
than
cap
gains)
• 20%
penalty
• Possible
interest
and
penal2es
for
late
payment
or
underpayment
– ER’s
perspec2ve
• Very
unhappy
employees!
• Withholding
obliga2on
• ER
por2on
of
employment
taxes
• Possible
responsibility
for
EE’s
por2on
of
withholdings
• Possible
legal
liability
if
sued
by
EE

13. 13
Overview
of
IRC
Sec2on
409A
• What
do
you
as
an
entrepreneur
need
to
know
to
stay
out
of
trouble?
– With
respect
to
op2ons
• ISOs
– These
have
always
been
required
to
be
recorded
at
FV
so
409A
really
didn’t
change
anything
– But
did
provide
some
guidelines
that
should
be
followed
related
to
valua2on
• Non-­‐quals
– Will
need
to
deal
specifically
with
409A
– General
409A
compliance
requirements
• Exercise
price
>=
FMV
of
underlying
common
stock
at
grant
date
• FMV
must
be
determined
by
the
“reasonable
applica2on
of
a
reasonable
valua2on
methodology”

14. 14
Overview
of
IRC
Sec2on
409A
• What
do
you
as
an
entrepreneur
need
to
know
to
stay
out
of
trouble?
– General
409A
compliance
requirements
• “Reasonable
valua2on
methodology”
must
include
considera2on
of:
– Tangible
and
intangible
assets
– PV
of
future
cash
flows
– MV
of
the
stock
of
similar
companies
– Recent
transac2ons
– Appropriate
premiums
and
discounts
• Must
be
within
12
months
of
when
valua2on
is
being
used
– Or
more
frequently
based
on
a
“significant
events”
in
the
business
– Safe
Harbor
Valua2on
Methods
• Safe
harbors
are
not
a
“silver
bullet”
– ShiWs
the
burden
of
proof
from
you
to
the
IRS
related
to
valua2on
– May
only
be
rebuGed
by
the
Internal
Revenue
Service
if
the
company's
applica2on
of
the
method
is
found
to
be
"grossly
unreasonable."

15. 15
Overview
of
IRC
Sec2on
409A
• What
do
you
as
an
entrepreneur
need
to
know
to
stay
out
of
trouble?
– Safe
Harbor
Valua2on
Methods
• Independent
appraisal
– Using
the
standard
valua2on
methodologies
• Illiquid
start-­‐up
– Uses
valua2on
factors
outlined
in
General
Rule
– WriGen
report
– Company
less
than
10
years
old
– Valua2on
performed
by
someone
with
significant
experience,
educa2on
and
training
in
this
area
(>=
5
years)
» CFO
» CEO
» Investment
banker
– Reasonable
expecta2on
that
no
change
in
control
within
90
days
or
IPO
within
180
day

16. 16
Overview
of
IRC
Sec2on
409A
• What
do
you
as
an
entrepreneur
need
to
know
to
stay
out
of
trouble?
– Safe
Harbor
Valua2on
Methods
• Binding
formula
– Use
formula
based
on
book
value,
mul2ple
of
earnings
or
combina2on
– Stock
transfers
must
be
restricted
– All
transac2ons
must
use
the
same
binding
formula

17. 17
Overview
of
IRC
Sec2on
409A
• What
are
best
prac2ces
at
various
stages
of
development?
– Founding
stage
• Founders
stock
and
restricted
stock
more
frequently
than
op2ons
• Using
general
valua2on
factors
is
imprac2cal
due
to
limited
amount
of
informa2on,
opera2ng
history,
etc.

18. 18
Overview
of
IRC
Sec2on
409A
• What
are
best
prac2ces
at
various
stages
of
development?
– Start-­‐up
• Friends
and
family
or
some
angel
financing
• Op2on
issuances
start
– Companies
are
looking
at
the
cost/benefit
of
gewng
a
valua2on
– Depends
on
your
and
the
BODs
risk
tolerance
• If
using
Illiquid
Start-­‐up
safe
harbor
– Document
qualifica2on
of
person
performing
the
calc
– Consult
outside
resources
– Get
BOD
approval
and
document
– For
as
long
as
you’re
using
the
value,
consider
impact
of
events
that
may
have
changed
the
value
• Be
aware
of
possibility
of
changes
in
control
in
the
near
term

19. 19
Overview
of
IRC
Sec2on
409A
• What
are
best
prac2ces
at
various
stages
of
development?
– Post-­‐start
up
• Venture
financing,
decent
amount
of
revenue
• Almost
all
companies
are
op2ng
for
a
formal
outside
valua2on
• Updated
annually
– Possibly
mid-­‐year
depending
on
what
developments
take
place
during
the
year
• More
likely
to
have
changes
in
control
at
this
stage
– Other
things
to
keep
in
mind
• There
has
not
been
any
case
law
in
this
area
yet
so
how
409A
will
be
applied
to
op2ons
in
prac2ce
is
s2ll
unclear
• Modifica2ons
to
op2ons
can
trigger
new
409A
considera2on
• In
acquisi2on
situa2on,
don’t
be
surprised
to
be
asked
for
documenta2on
of
compliance
with
409A

20. Standard
of
Value
• Fair
Market
Value
– Assumes
hypothe2cal
buyer
– This
is
standard
for
409A
(per
IRS)
• Investment
Value
– Assumes
strategic
buyer
409A
≠
VC
investment
20

21. Standard
of
Value
• Fair
Market
Value
• Rev.
Rule
59-­‐60
“The
price
at
which
the
property
would
change
hands
between
a
willing
buyer
and
a
willing
seller,
neither
being
under
any
compulsion
to
buy
or
sell,
and
both
having
reasonable
knowledge
of
relevant
facts.”
• Important
because
this
does
not
assume
a
strategic
buyer.
This
is
the
standard
for
409A.
21

22. Standard
of
Value
• Investment
Value
• “The
value
to
a
par2cular
investor
based
on
individual
investment
requirements
and
expecta2ons”.
• Value
is
different
depending
on
synergies.
• Applies
to
specific
buyer
rather
than
hypothe2cal
buyer.
• Investment
value
is
usually
higher
than
fair
market
value
because
of
synergies,
and
specific
buyer
is
inves2ng
for
poten2al
return
in
the
future.
22

23. Three
Valua2on
Methods
1. Asset
Approach
2. Market
Approach
3. Income
Approach
23

24. 1.
Asset
Approach
• Applicable
only
for
companies
in
early
stage
(difficult
to
defend,
last
resort
if
there
are
no
other
data
points)
• The
Asset
Approach
establishes
value
based
on
the
cost
of
reproducing
or
replacing
the
property,
less
deprecia2on.
• Applied
to
specific
assets,
such
as
land
improvements,
special-­‐purpose
buildings,
special
structures,
systems,
special
machinery
and
equipment,
and
certain
intangible
assets.

25. 2.
Market
Approach
• Based
on
the
assump2on
that
the
value
of
an
asset
(including
a
company)
is
equal
to
the
value
of
a
subs2tute
asset
with
the
same
characteris2cs.
• Infer
value
by
finding
similar
assets
that
have
been
sold
in
recent
transac2ons.
• Similar
to
real
estate
transac2ons.

26. 2.
Market
Approach
a) Recent
securi?es
transac?on
method.
Based
on
recent
transac2ons
of
company’s
securi2es
Ex:
preferred
stock
sold
to
angels.
Backsolve
method
uses
OPM
based
on
preferred
rights.
b) Comparable
public
co.
Uses
revenue
and
EBITDA
mul2ples
from
companies
in
same
industry.
c) Comparable
transac?on
method.
Similar
to
b)
but
uses
private
company
transac2ons
from
databases
such
as
CapIQ
and
Bloomberg.
d) Industry
specific
mul2ples
(N/A).
Ex:
headcount,
backlog,
revenue
per
employee,
#
of
customers,
#
of
users.

27. 3.
Income
Approach
• Discounted
Cash
Flows
(DCF).
• Present
value
of
future
cash
flows.
• Discount
rate
is
based
on
rela2ve
riskiness
of
investment.
• Use
this
method
if
can
reasonably
rely
on
projec2ons.

28. 2b.
Market
Example:
Guideline
Public
Company
Method
Data
for
similar
public
companies
in
same
industry.
For
our
example
company,
Venture
Co,
these
are
comparable
public
companies:
• Salesforce.com,
Inc.
• Concur
Technologies,
Inc.
• Kenexa
Corp.
• LogMeIn,
Inc.
• Constant
Contact,
Inc.
For
example,
Salesforce
has
a
market
cap
of
$31B
which
is
the
“value”
of
the
company
(market
cap
is
the
stock
price
*
number
of
share
outstanding).
Salesforce
has
revenues
of
$6.2B.
Therefore,
the
mul2ple
is
$31B
/
6.2B
=
5
Analyst
takes
average
mul2ples
of
all
applicable
companies.
28

29. 2b.
Market
Example:
Guideline
Public
Company
Method
29
• This
chart
for
Venture
Co.
applies
the
average
mul2ples
to
the
revenue
and
EBITDA
to
calculate
vaue.
• Since
EBITDA
is
nega2ve,
it
is
not
considered.

30. Steps
in
the
Valua2on
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
Remember
that
the
purpose
of
409A
is
to
value
common
stock
30

31. Valuation
7
Step 1 – Determine enterprise value using weighted
average of applicable methods (Asset, Market and Income)

32. Step
2:
Alloca2on
• Simply
means
“who
gets
what”
in
the
event
of
an
exit
• Common
shareholders
get
paid
aWer
preferred
32

33. Alloca2on
Methods
• Current
Value
Method
(“CVM”)
–
assumes
value
today
is
same
as
exit
value
– Appropriate
only
if
liquidity
value
is
known
as
in
a
pending
deal
• Probability
Weighted
Expected
Return
(“PWERM”)
–
weighted
average
of
various
scenarios
based
on
probability
(IPO,
sale,
bankruptcy)
– Probability
based
on
appraiser’s
judgment
• Op2on
Pricing
Method
(“OPM”)
–
same
logic
as
PWERM
but
considers
more
scenarios
– Probability
based
on
Black
Scholes

34. Op2on
Pricing
Method
“OPM”
• In
the
event
of
an
exit,
preferred
gets
paid
first
• Common
only
gets
if
there’s
anything
leW
over
• Vola2lity
and
2me
to
liquidity
are
important
factors
in
determining
range
of
outcomes
• Greater
vola2lity
is
beGer
for
common
(lower
lows
but
who
cares
because
below
zero
is
same
as
zero)
• Longer
life
is
beGer
because
more
opportunity
to
grow

35. OPM
• See
Exhibit
on
following
slide.
• Common
stock
only
has
value
only
if
funds
available
exceed
liquida2on
preferences
of
preferred.
• The
OPM
takes
the
weighted
average
of
various
exit
scenarios
(IPO,
M&A,
liquida2on)
and
calculates
the
alloca2on
among
the
classes
of
stock.

36. 36

37. Summary
• STEP
1
Enterprise
Value
$48,153,573
Less
Debt
(1,750,000)
Equity
Value
$46,403,573
• STEP
2
Alloca2on
to
common
$15,051,167
Divided
by
#
shares
÷
20,000
Price
per
share
=
$0.753
37

38. Discount
• Private
company
stock
cannot
be
sold
on
the
public
stock
markets.
Analyst
applies
a
discount
to
reflect
this
liquidity
issue.
• 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
38

39. Other
Points
• Value
is
based
on
a
number
of
assump2ons
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
assump2ons.
You
know
your
business.
39

40. 40
QUESTIONS
AND
ANSWERS

41. 41
Thank
You!
ScoG
Goodwin,
CPA
sgoodwin@wolfandco.com
(617)
428-­‐5407
Alicia
Amaral
alicia.amaral@scalaranaly2cs.com
(617)
684-­‐5510

42. 42
Resources
Internal
Revenue
Bulle?n:
2007-­‐19,
Applica?on
of
Sec?on
409A
to
Nonqualified
Deferred
Compensa?on
Plans
-­‐
hRp://www.irs.gov/irb/2007-­‐19_IRB/ar07.html
IRS
Revenue
Ruling
59-­‐60
-­‐
hRp://www.nuRer.com/media/news/media.670.pdf
AICPA
Valua?on
of
Privately-­‐Held
Company
Equity
Securi?es
Issued
as
Compensa?on
-­‐
hRp://www.wolfandco.com/tcn

43. 43
Resources
To
be
posted
to
TCN
website:
• Detailed
outline
and
PowerPoint
presenta?on
• Scalar
Analy?cs
–
white
paper,
“Sec?on
409A
–
Common
Stock
Valua?on”