409A Compliance

1
409A Compliance Issues, Approaches and Mistakes
Not to Make
A Teleconference from Business Valuation
Resources 1-888-BUS-VALU (287-8258) www.bvresource
s.com info_at_bvresources.com May 2,
2007 Moderator Bob Duffy, CPA/ABV, CFA, ASA of
Grant Thornton LLP Panelists Scott Beauchene,
CFA, ASA of Grant Thornton LLP Joel Johnson, ASA
of Orchard Partners, Inc.
2
Ancillary Reading Materials

• 409A Compliance Issues, Approaches and Mistakes
  Not to Make PDF and PowerPoint Presentation
• The final 409A regulations http//www.ustreas.gov
  /press/releases/hp345.htm
• Getting Ready for 409A Some Practical
  Considerations article by Scott Beauchene and
  Robert Duffy, published in the May 2007 Business
  Valuation Update
• Be Careful When Pricing Employee Stock Options
  article by Joel Johnson, published in the
  February 2006 issue of M A Today
• A Method for Valuing High-Risk, Long-Term
  Investments The "Venture Capital Method by
  William Sahlman and Daniel Scherlis
  http//custom.hbsp.com/b01/en/implicit/viewFileNav
  BeanImplicit.jhtml?_requestid46073
• All downloads available at the BVR Teleconference
  ancillary reading materials page
  http//www.bvresources.com/defaulttextonly.asp?ft
  creading050207

3
Learning Objectives

• Understand the need for and requirements of 409A
  valuation engagements
• Compare and contrast Fair Market Value and Fair
  Value
• Understand the relationship between 409A and 123R
  and the significance of the AICPA Practice Aid
• Discuss applicability and magnitude of lack of
  control and lack of marketability discounts
• Learn practical tips and methods for interacting
  with an auditor

4
Submitting Questions

• Email tc-questions_at_bvresources.com at any time
  during the Teleconference
• The final 20-30 minutes is dedicated to telephone
  questions the conference operator will announce
  QA time and provide instructions on how to join
  the queue

5
What is 409A?
6
What is 409A?

• In October 2004, as part of the American Jobs
  Creation Act of 2004, the IRS issued Code Sec.
  409A, assessing penalties if option strike prices
  not at least at fair market value of the common
  stock
• Requires that the valuation of the common stock
  be based on a reasonable application of a
  reasonable valuation method
• Presumption of reasonableness in 3 instances
  1) valuation by independent appraiser, 2) FMV
  formula applied in transactions, or 3) written
  report for illiquid stock of a start-up
  corporation
• If the appraisal is performed by an independent
  qualified individual, then the value is
  presumptively fair market value

7
What is 409A? continued

• A safe harbor provision states that, in certain
  circumstances, a valuation is assumed to reflect
  FMV unless it can be shown that the valuation is
  grossly unreasonable
• One of these provisions, the illiquid start-up
  presumption, has been shortened to 90 days for
  change of control transactions and 180 days for
  an IPO
• This means that if, at the time the valuation is
  performed, the Company does not reasonably
  anticipate a change of control within 90 days or
  an IPO within 180 days of the valuation date, the
  illiquid start-up presumption applies

8
What are the Characteristics of a Typical 409A
Client?
9
What are the Characteristics of a Typical 409A
Client?

• The company is issuing options
• A liquidity event is expected within five years
• The company may be venture backed, and its
  complex capital structure with multiple classes
  of preferred stock may preclude simplistic
  approaches to valuation
• Board of Directors of Subject Company requires
  assistance of independent valuation specialist in
  setting option strike price
• Client may need the valuation for IRS purposes
  only, but most often the valuation is used for
  income tax and financial reporting compliance

10
Who is the Audience for a 409A Appraisal?
11
Who is the Audience for a 409A Appraisal?

• The IRS Comfortable with discounts, aware of tax
  court decisions
• The SEC Uncomfortable with discounts, oriented
  toward the rules for financial reporting
• The companys auditor Needs a report that can be
  audited
• The board of directors Understands value, but
  unlikely to appreciate valuation techniques
• Management Varying levels of sophistication
• The recipient Wants a low value, but is the
  potential victim if value is below FMV
• Potential acquirers Looking for a liability

12
What Guidance and Regulations Apply to a 409A
Appraisal?
13
What Guidance and Regulations Apply to a 409A
appraisal?

• In April 2007, final regulations on Code Sec 409A
  were issued (with an effective date of January 1,
  2008)
• Download the final regulations at
  http//www.ustreas.gov/press/releases/hp345.htm
• Before 409A, in the early 2000s, the SEC asked
  the AICPA to provide guidance on the allocation
  of value between preferred and common shares
• The AICPA responded by publishing a Practice Aid
  in 2004 named Valuation of Privately-Held-Company
  Equity Securities Issued as Compensation
• Rejects rules of thumb and advocates the use of
  a contemporaneous appraisal by an unrelated
  valuation specialist

14
What Guidance and Regulations Apply to a 409A
appraisal? continued

• There is an assumption that the Practice Aid
  represents best practices, but the IRS has not
  indicated whether or not it will follow the
  Practice Aid
• In 2005, the FASB issues FAS 123R, requiring the
  expensing of stock options issued as compensation
  to employees
• Under FAS 123R, it is necessary for nonpublic
  entities to determine the fair value of their
  shares
• Thus, the company may have a tax need (under
  409A) and a financial reporting need (under FAS
  123R)

15
How Does Fair Market Value Compare to Fair Value?
16
How does Fair Market Value Compare to Fair Value?

• Rev Rul. 59-60 defines fair market value as the
  price at which the property would change hands
  between a willing buyer and a willing seller,
  when the former is not under any compulsion to
  buy and the latter is not under any compulsion to
  sell, both parties having reasonable knowledge of
  relevant facts
• FAS 157, Fair Value Measurements defines fair
  value as the price that would be received to
  sell an asset or paid to transfer a liability in
  an orderly transaction between market
  participants at the measurement date

17
How does Fair Market Value Compare to Fair Value?
continued

• To date, neither the SEC nor the IRS has stated
  definitively whether these two standards of value
  would result in similar valuation conclusions
• In May 2003, the FASB stated that fair value, as
  refined, is consistent with the definition of
  fair market value in IRS Rev Rul. 59-60 to
  date, this comment has not been rescinded or
  modified

18
Certain Differences Do Exist Between Fair Value
and Fair Market Value

• Fair value follows a specified hierarchy of
  assumptions and inputs while fair market value
  has no stated hierarchy or preference
• Fair value disallows blockage discounts while
  fair market value does not
• SEC employees have stated in a private
  conversation that the SEC does not possess
  sufficient knowledge of fair market value to say
  whether a similar or disparate conclusion would
  be reached under both standards
• IRS employees, in a private conversation, stated
  the IRS had a similar lack of knowledge about
  fair value
• The Practice Aid states that the current method
  be used only in certain limited circumstances
  the IRS has no such prohibition

19
How Difference Applies to Minority Common Stock
Valuations

• The GAAP-based hierarchy and blockage discount
  prohibition should, in most cases, result in
  little difference between fair value and fair
  market value
• The lack of prohibition against the current value
  method in 409A guidance could result in
  significant differences
• The Practice Aid valuation approaches and the
  auditor/SEC audience indicate smaller discounts
  should be applied in fair value assignments
• The IRS, on the other hand, has not provided
  guidance on valuation approaches and has
  historically been more open to discounts

20
How Difference Applies to Minority Common Stock
Valuations continued

• Practical questions exist in that, if in the
  future the clients company requires both an
  IRS-compliant and a financial reporting-compliant
  valuation, how and should you reconcile between
  the two standards of value
• Do comments from the auditor and/or SEC affect a
  conclusion of value for tax purposes?

21
The AICPA Practice Aid
22
For a Combined 409A/123R Appraisal, Most Auditors
Will Expect the Appraiser to Follow the Practice
Aid

• What the Practice Aid is and is not
• Not intended to focus on the value of the
  enterprise as a whole
• Is intended to provide guidance to management,
  BOD, auditors, and other interested parties
• Not intended to serve as a detailed how to
  guide
• overview and understanding of the valuation
  process
• best practice recommendations
• Intended to move past rule of thumb and
  historical cost based methods
• Intended to capture future value scenarios

23
Two Parts to the Analysis when Complex Capital
Structure Exists

• Estimate the enterprise value
• Allocate the value to different equity classes
  such as preferred and common stock

24
Enterprise Value Methods

• Enterprise value can be estimated based on
  traditional cost, market, and income approaches
• The latest round of financing can represent a
  market approach indication of value of the
  recently issued preferred
• The pre-money value from the term sheet plus the
  current round is not a reliable measure of
  enterprise value

25
Enterprise Allocation Methods

• Current-Value Method (CVM)
• Option-Pricing Method (OPM)
• Probability-Weighted Expected Return Method
  (PWERM)

26
Current Value Method

• Current Value allocates current value of the
  enterprise to each class of security based on its
  present rights, preferences and conversion
  features (i.e., ignores preferred's ability to
  defer the conversion decision)

27
Current Value Method continued

• Is appropriate in two limited circumstances
• A liquidity event is imminent that does not force
  the conversion of preferred into common
• The enterprise is at such an early stage of
  development that
• No material progress has been made on the
  business plan
• No significant common equity value has been
  created
• There is no reasonable basis for estimating the
  amount and timing of probable future common value
• Benefit of current value method is that it is
  easy to use and easy to understand
• Drawback is that it is applicable to only a
  narrow range of circumstances

28
Option-Pricing Method

• Treats common and preferred stock as call options
  on enterprise value
• Utilizes Black-Scholes or binomial models to
  calculate value
• Is useful for valuing securities when there is a
  high degree of uncertainty regarding their
  potential future values
• Is sensitive to estimates of volatility and
  term/life
• Does not capture the effects of potential future
  radical spikes in value as well as probability
  weighted model
• Benefit of OPM a relatively objective approach
  to allocating value when uncertainty is high
• Drawback of OPM is that it can be difficult to
  explain and understand

29
Probability Weighted Expected Return Method

• Rooted in decision-tree analysis
• Models potential future expected outcomes (sale
  or merger IPO dissolution or continuation as a
  going concern)
• Encompasses the following steps
• Estimate future values for each potential outcome
• Allocate future value to each share class
• Discount to present value, by class, these
  potential future values
• Assign probabilities to each outcome
• Estimate share value by summing the
  probability-weighted outcomes

30
Probability Weighted Expected Return Method
continued

• Unlike the OPM, this method determines enterprise
  value and allocates value at the same time
• Benefit relatively easy to understand and use
• Drawback subject to significant judgment

31
Selecting an Allocation Method

• Does the method reflect the going concern
  expectations of each class of security holder?
• Does the method ascribe some value to the common
  stock if the company is not in liquidation?
• Can the results be independently replicated or
  approximated?
• Do the benefits of using the model exceed the
  cost of implementation?

32
How to Handle the Price Paid for Preferred Shares
33
How Do You Handle the Price Paid for Preferred
Shares?

• Often the appraisal date is the date of a
  preferred financing
• How does the price paid for the preferred shares
  enter into the valuation analysis?
• Enterprise Value Term Sheet Pre-money
• Value of the current preferred round multiplied
  by the existing outstanding shares (and expanded
  option pool)
• Using this as an enterprise value presumes that
  all equity is equally valuable
• The point of allocating to different equity
  classes is to capture the differences

34
Not all Preferred Has the Same Terms
Q4 2006 Q3 2006 Q2 2006 Q1 2006
Multiple LP 14 26 16 14
1-2X LP 40 90 83 80
2-3X LP 60 10 0 20
gt 3X LP 0 0 17 0
Participation 73 64 71 65
Source Fenwick West
35
Assume 1 Million Shares Outstanding 2.5
Million Is Raised at 5.00 Per Share

• First VC
• 1X LP
• No participation

• Second VC
• 2X LP
• Participation

• Pre-money value is 5 million in both cases
• 1,000,000 shares x 5 5,000,000
• 500,000 shares x 5 2,500,000
• 5,000,000 2,500,000 7,500,000

36
Assume Business Is Sold for 10,000,000

• First VC
• LP is 2,500,000
• Conversion value is 10,000,000 x 33
  3,333,000
• Proceeds to remaining common shareholders
  10,000,000 - 3,333,000 6,667,000

• Second VC
• LP is 5,000,000
• Proceeds after payout of LP 10,000,000 -
  5,000,000 5,000,000
• Participation is 5,000,000 x 33 1,667,000
• Proceeds to remaining common shareholders
  5,000,000 - 1,667,000 3,333,000

37
How Do You Handle the Price Paid for Preferred
Shares? continued

• Enterprise Value Through Allocation Methods
• We said the Practice Aid intended to capture
  value scenarios
• From a common stock holders perspective, when
  dividends are not paid, the future liquidity
  event reflects the total return expectation for
  the investment
• Whether you use the Option Method or Probability
  Scenario the future values relate to the
  enterprise value as of the valuation date

38
Liquidity Allocation Scenarios Viewed through
Binomial Model
39
Allocation Scenario Example refers to chart

• Liquidation scenario range The orange range
  reflects the liquidation preference of the Series
  A exceeds the enterprise value
• Transaction scenario range In the blue range,
  preferred and common receive pro rata
  distributions
• In the top range, amounts above 5/share,
  automatic conversion or an IPO would likely occur

40
IPO Scenario

• Reflected as part of a normal distribution range
  here but could also be a discrete outcome in the
  PWERM
• Each outcome can be tested in the binomial model
  due to the transparency
• For example, at outcomes above 41MM, each class
  receives its pro rata share of the value
• At asset value of 61.43 x 25.52 15.68,
  common stock value

41
Results of Using Latest Round Post-Money Value

• Post-money value is a mechanism to allocate
  future share of the company should all classes of
  equity be treated equal
• If the post-money value is used as the starting
  point in the option model or results from
  probability-weighted scenarios, the value of the
  current round is distorted and results in a
  non-meaningful common allocation (see chart on
  next slide)

42
Comparison of Latest Round Results
Original Issue Price Based on Series A Price EV Based on Pre-Money Term Sheet EV

Series A Preferred Stock 1.6600 1.66 1.97
Common - 0.53 0.76
Total 1.37 1.66

• Preferred priced at 19 premium on "day 2"
• Common priced at 43 premium

43
Solve-for Value

• A reasonableness check or alternative method for
  calculating the enterprise value can be used
• The constant is that the latest round price must
  approximate the model allocation
• For the option model, this means finding the
  enterprise value that results in the issue price
  of the latest preferred
• The issue price of the preferred, not common
• For the PWERM, this means that the selected
  inputs such as probabilities, liquidity event
  values, and present value discount rates should
  result in a value allocated to the preferred
  value consistent with the latest round price

44
A Few Caveats About Using the Practice Aid
45
Factors Not Considered in the Enterprise Value
Allocation Methods Per the Practice Aid

• Economic - Liquidity
• Mandatory redemption rights and registration
  rights, whose objective is to enhance preferred
  stock liquidity and first refusal rights and
  co-sale rights, whose objective is to protect
  preferred value
• Economic Valuation
• Antidilution rights, protecting against future
  declines in value
• Control (and Influence)
• Voting rights, protective provisions and veto
  rights, board composition rights, drag-along
  rights, co-sale rights, management rights, and
  information rights

46
How to Adjust for Future Levels of Cash and Debt

• Estimate future use or generation of cash?
• Amortize debt?
• Factor in option proceeds?

47
Using the PWERM

• Do the probabilities represent an additional
  adjustment for risk? How do the probabilities
  affect the discount rate?
• How many scenarios to consider? How to determine
  a liquidity date?
• Does a venture backed company ever elect to
  remain private?
• How to handle the dilutive effect of future
  financings?

48
Application of Minority Interest Discounts

• Applicable to the remain private scenario and
  not the future sale scenario?

49
Discount for Lack of Marketability

• Applicable to only the remain private scenario?
• When does the discount rate already include a
  discount for lack of marketability?

50
How to Handle the Discount for Lack of Control
(DLOC) and the Discount for Lack of Marketability
(DLOM)
51
How to Handle DLOC and DLOM

• Sharp difference between IRS and SEC perspectives
• Factors to consider with discounts for lack of
  control and lack of marketability
• Option or scenario model dependent
• Starting enterprise value dependent
• Company stage of development/time to liquidity
• Path or scenario dependent
• Company enterprise perspective or individual
  perspective
• Dilution from future financing rounds
• Discounts based on disproportionate rights (see
  table on next slide)

52
How to Handle DLOC and DLOM
Interests of Preferred Stockholders Compared with Common Interests of Preferred Stockholders Compared with Common
Less Aligned More Aligned
Fair value below liquidation preference Significant fair value above liquidation preference
Fair value is between the liquidation preference of preferred, but less than the conversion price in non-participating preferred Fair value is above conversion threshold of non-participating preferred
No automatic conversion, significantly below automatic conversion price or transaction type does not require conversion Automatic conversion, likely scenario is IPO with automatic conversion
Additional financing rounds required resulting in disproportionate dilution to common No additional financing necessary
53
Use of Quantitative Models for Discounts

• Advantage Can be audited
• Disadvantage Subject to garbage-in, garbage-out
  and dangerous when used without other analysis
  and judgment
• Disadvantage Appeal of math clouds judgment of
  applicability
• Advantage Addresses key SEC concerns of
  volatility and duration

54
Quantitative Models Seen Used

• Restricted stock regression analysis (i.e.,
  Longstaff)
• Put option
• Put-call collar
• Proprietary models

55
Additional Commentary on Quantitative Models

• Theoretical models built off liquid security data
• Do not reflect the costs of executing the
  derivative strategies
• Locks in a price today, doesnt reflect present
  value impact of receiving a specified price in
  the future
• Proprietary models cannot be audited

56
Tips for Producing a Report That Satisfies Both
Goals Tax and Financial Reporting
57
Tips for Producing a Report

• Follow the Practice Aid
• Consult with the auditor as necessary
• Be aware that there will be a need to update the
  report annually if not more often
• Will the assumption result in a material impact
  on financial statements if reasonable
  professionals would come up with difficult
  assumptions?
• If the assumptions are material, what can be done
  to support why another assumption would not be
  more appropriate?

58
Tips for Producing a Report continued

• Perception matters in valuation for accounting
  purposes, motivations in stock option grant price
  setting are well known
• Since methods are still evolving, there are gray
  areas of interpretation
• The best approach is to consider the big picture,
  step back, and determine whether the conclusions
  are reasonable rather than to take the Practice
  Aid or any other tool and use form over substance

59
Questions?

• Email tc-questions_at_bvresources.com at any time
  during the Teleconference
• The conference operator will provide instructions
  on how to ask live questions

60
Thank You for Attending!

• Visit www.bvresources.com/conferences for a
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61
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