Straight Talk on 409A Valuations: Getting It Right the First Time. Wednesday, June 6, 2:00 p.m. ET

Transcription

1 Straight Talk on 409A Valuations: Getting It Right the First Time Wednesday, June 6, 2:00 p.m. ET

2 Administrative Items All lines are muted. Please use the Questions Tab to send a question to our panelists. Today's webinar is being recorded and will be sent to all attendees after the event.

3 What You'll Learn Today Why you should consider getting a 409A valuation and the legal, tax, and financial reporting consequences of non-compliance. When is the right time to get your first valuation and how often you ll need an update. What information you ll need to provide to your legal, valuation and audit service providers. Common problems and pitfalls you will want to avoid. What to do if you are not satisfied with your valuation.

4 Today's Speakers Dave Broadwin Partner, Foley Hoag LinkedIn: Online: Blog: Ed Sullivan Audit Partner, KPMG LinkedIn: Online: Channing Hamlet Managing Director, Cabrillo Advisors LinkedIn: 0/129/824 Online: Gary Levine CEO, Corporate Focus LinkedIn: Online:

5 What Is 409A? A section of the Internal Revenue Code that governs certain deferred compensation including options Deferred Compensation is a legally binding right to compensation that arises in one tax year and may be paid in a later tax year. Options are rights to acquire stock in the future. Dave Broadwin Partner, Foley Hoag

6 What Are the Consequences of Non-Compliance? Inclusion in income and a 20% penalty tax at the time the right vests For options: o Income at the time of vesting (even if not exercised) o 20% penalty o Same tax penalty on each value increase each year Dave Broadwin Partner, Foley Hoag

7 What Payments Are Exempt? Payments that meet the short term deferral rule Payments that meet the 2 times/2 year rule Compliant option grants Certain others o 401(k) payments o Welfare benefits Dave Broadwin Partner, Foley Hoag

8 Short Term Deferral Rule This rule exempts payments made no later than 2 ½ months after the later of (a) employee s or (b) employer s taxable year in which the right to deferred compensation vests. Dave Broadwin Partner, Foley Hoag

9 2 Times/2 Year Rule Applies to cases of involuntary termination o The payment must be the less than the lesser of (a) 2 times annual compensation or (b) 2 times the IRS limit on compensation for tax qualified plans. o Must be paid within 2 years of termination. Dave Broadwin Partner, Foley Hoag

10 Option Issues Must be for common stock Must be issued for service recipient stock Must have an exercise price not less than the fair market value on the date of grant Must state a fixed number of shares on the date of grant Must be taxable when exercised Must not defer income beyond exercise or disposition NB - These rules are for non-qualified stock options. Qualified options have their own exemption and are not taxable when exercised. Dave Broadwin Partner, Foley Hoag

11 Pricing Option Grants Guess (toast if you are wrong) Internal valuation by a sophisticated BOD member Pay outside firm to do valuation Dave Broadwin Partner, Foley Hoag

12 Process Overview AICPA Prescribed Methodology for Deferred Compensation Programs outlined in the practice aid Required every twelve months or sooner if there is a material change in the business Consistent with IRS Revenue Rule 59-60, must evaluate internal and external factors Internal Factors Milestones achieved Management experience / track record Workforce skill Existence of intellectual property Advantageous business relationships Financial performance, etc. External Factors State of the industry / economy Competitive landscape Industry attractiveness Barriers to entry, etc. Channing Hamlet Managing Director, Cabrillo Advisors

13 Three Step Process Step 1: Business Enterprise Value Step 2: Allocate Among Equity Classes Step 3: Consider Discounts Common Enterprise Value Approaches Market Approach: Review of publicly-traded companies and valuations for recent private transactions for similar businesses Income Approach: Based on the present value of anticipated future cash flows (aka Discounted Cash Flow) Asset Approach: Value of both tangible and intangible assets Channing Hamlet Managing Director, Cabrillo Advisors

14 Three Step Process Step 1: Business Enterprise Value Step 2: Allocate Among Equity Classes Step 3: Consider Discounts AICPA Prescribed Methods Option Pricing Method: Black-Scholes model to allocate the Company's value between the different classes of equity Probability Weighted Expected Return Method: Based upon an analysis of scenarios (IPO, acquisition, bankruptcy, etc.) The Current-Value Method: The Common Stock equity value is determined by subtracting the liquidation preference of the Preferred Stock Channing Hamlet Managing Director, Cabrillo Advisors

15 Three Step Process Step 1: Business Enterprise Value Step 2: Allocate Among Equity Classes Step 3: Consider Discounts Discounts Lack of Control: Account for the lack of control. Appropriate in the event that the Enterprise Value is conducted on a control interest basis. Lack of Marketability: Account for the lack of marketability of the subject stock, based on a number of factors (such as expected time to liquidity and transfer restrictions) Channing Hamlet Managing Director, Cabrillo Advisors

16 Information Requirements Generally try to work with information available. Following are the high level information requirements: Financial Data o o Historical financial statements Projected financial statements Capital Structure o o o Cap table, listing all classes of securities including options, warrants, etc Articles of Incorporation describing the terms and rights of each class of stock Terms of debt and convertible debt Business Information o o o Business plan or investor pitch materials Risks and opportunities Research and analysis of competition Other Information o o History of all transactions in company securities Disclosure of pending transactions Channing Hamlet Managing Director, Cabrillo Advisors

17 Observations and Pitfalls The "rule of thumb" of taking the Preferred Price and dividing it by 8 or 10 is no longer an acceptable or appropriate method There are a number of future audiences that need to be considered (all of whom will have the benefit of hindsight) o IRS: While the IRS has not yet challenged valuations, it has to be a primary factor in evaluating a valuation o CPA Firm: Can serve as an input for financial reporting (stock compensation expenses) o Acquirer: Will require you to represent compliance with tax issues including 409a and may review valuations to verify o SEC: In the event your company pursues an IPO, the SEC will carefully review valuations 409A is important since it is tough to correct mistakes made with option grants Channing Hamlet Managing Director, Cabrillo Advisors

18 409A Auditor's Perspective Why is this topic relevant to your auditor? o Impact on financial statements to be audited o Impact of cheap stock reviews in initial public offering process Most common myth/rule of thumb (10:1 ratio) o Investor interest in value of options o Regulator interest in value of options When should I have a valuation performed (and how often)? o Pre-revenue, post-revenue? o Annual, quarterly or more frequently? o In conjunction with a round of investment or financing? Ed Sullivan Audit Partner, KPMG

19 409A Auditor's Perspective Who should I hire to perform the valuation? o Sole practitioner o Small firm o Large firm o Internal Resource When should I get my auditor involved? o Initial planning o Upon issuance of a draft report o After issuance of final report o Impact on Board approvals o Impact of completion of financial statement audits Ed Sullivan Audit Partner, KPMG

20 Closing Thoughts Three Perspectives on 409A Valuations: Legal Adviser Valuation Provider Audit Firm

21 Questions Answers from Panelists

22 Connect with Us Read our Blog: LinkedIn Group: Search for "Corporate Focus Professional Network" Main Number: (800)