Valuing Intangible Assets for Financial Reporting

1

409A Compliance –

Issues, Approaches and

Mistakes Not to Make

A Teleconference from Business Valuation Resources

1-888-BUS-VALU (287-8258) www.bvresources.com

info@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.

Business Valuation Resources Teleconference

May 2 nd , 2007 – 409A Compliance – Issues, Approaches and Mistakes Not to Make

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/viewFileNavBeanImplicit.jhtml?_requestid=460

73

• All downloads available at the BVR Teleconference ancillary reading materials page: http://www.bvresources.com/defaulttextonly.asp?f=tcreading050207

2



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

3



Submitting Questions

• Email tc-questions@bvresources.com

at any time during the Teleconference

• The final 20-30 minutes is dedicated to telephone questions; the conference operator will announce Q&A time and provide instructions on how to join the queue

4



5

What is 409A?



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

6



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

7



8

What are the Characteristics of a Typical 409A Client?



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

9



10

Who is the Audience for a

409A Appraisal?



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 company’s 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

11



12

What Guidance and

Regulations Apply to a 409A

Appraisal?



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”

13



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)

14



15

How Does Fair Market Value

Compare to Fair Value?



How does Fair Market Value Compare to

Fair Value?

16

• 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”



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

17



Certain Differences Do Exist Between Fair

Value and Fair Market Value

18

• 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



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

19



How Difference Applies to Minority

Common Stock Valuations [continued]

• Practical questions exist in that, if in the future the client’s 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?

20



21

The AICPA Practice Aid



For a Combined 409A/123R Appraisal,

Most Auditors Will Expect the Appraiser to

Follow the Practice Aid

22

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



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

23



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

24



Enterprise Allocation Methods

• Current-Value Method (CVM)

• Option-Pricing Method (OPM)

• Probability-Weighted Expected Return Method (PWERM)

25



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)

26



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



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

28



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

29



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

30



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?

31



32

How to Handle the Price Paid for Preferred Shares



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

33



Not all Preferred Has the Same Terms

Multiple LP

1-2X LP

2-3X LP

> 3X LP

Participation

Q4 2006

14%

40%

60%

0%

73%

Q3 2006

26%

90%

10%

0%

64%

Q2 2006

16%

83%

0%

17%

71%

Q1 2006

14%

80%

20%

0%

65%

34

Source: Fenwick & West



Assume 1 Million Shares Outstanding &

$2.5 Million Is Raised at $5.00 Per Share

35

First VC Second VC

• 1X LP

• No participation

• 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



Assume Business Is Sold for $10,000,000

First VC Second 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

• 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

36



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 holder’s 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

37



38

Liquidity Allocation Scenarios

Viewed through Binomial Model

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

11.26

12.96

9.77

14.93

11.26

8.48

17.20

12.96

9.77

7.36

19.82

14.93

11.26

8.48

6.39

22.83

17.20

12.96

9.77

5.55

26.29

19.82

14.93

11.26

8.48

6.39

4.82

30.29

22.83

17.20

12.96

9.77

7.36

5.55

4.18

34.89

26.29

19.82

14.93

11.26

8.48

6.39

4.82

3.63

40.19

30.29

22.83

17.20

12.96

9.77

7.36

5.55

4.18

3.15

46.29

34.89

26.29

19.82

14.93

11.26

8.48

6.39

4.82

3.63

2.74

53.33

40.19

30.29

22.83

17.20

12.96

9.77

7.36

5.55

4.18

3.15

2.38

61.43

46.29

34.89

26.29

19.82

14.93

11.26

8.48

6.39

4.82

3.63

2.74

2.06

70.76

53.33

40.19

30.29

22.83

17.20

12.96

9.77

7.36

5.55

4.18

3.15

2.38

1.79

81.51

61.43

46.29

34.89

26.29

19.82

14.93

11.26

8.48

6.39

4.82

3.63

2.74

2.06

1.55

7.36

5.55

4.18

3.15

2.38

1.79

1.35

93.89

70.76

53.33

40.19

30.29

22.83

17.20

12.96

9.77

8.48

6.39

4.82

3.63

2.74

2.06

1.55

1.17

108.15

81.51

61.43

46.29

34.89

26.29

19.82

14.93

11.26

9.77

7.36

5.55

4.18

3.15

2.38

1.79

1.35

1.02

124.58

93.89

70.76

53.33

40.19

30.29

22.83

17.20

12.96

11.26

8.48

6.39

4.82

3.63

2.74

2.06

1.55

1.17

0.88

143.51

108.15

81.51

61.43

46.29

34.89

26.29

19.82

14.93

12.96

9.77

7.36

5.55

4.18

3.15

2.38

1.79

1.35

1.02

0.77

165.31

124.58

93.89

70.76

53.33

40.19

30.29

22.83

17.20

14.93

11.26

8.48

6.39

4.82

3.63

2.74

2.06

1.55

190.42

143.51

108.15

81.51

61.43

46.29

34.89

26.29

19.82

1.17

0.88

0.67

17.20

12.96

9.77

7.36

5.55

4.18

3.15

2.38

1.79

219.35

165.31

124.58

93.89

70.76

53.33

40.19

30.29

22.83

1.35

1.02

0.77

0.58

22.83

17.20

12.96

9.77

7.36

5.55

4.18

3.15

2.38

291.05

219.35

165.31

124.58

93.89

70.76

53.33

40.19

30.29

1.79

1.35

1.02

0.77

0.58

0.44

19.82

14.93

11.26

8.48

6.39

4.82

3.63

2.74

2.06

252.67

190.42

143.51

108.15

81.51

61.43

46.29

34.89

26.29

1.55

1.17

0.88

0.67

0.50

26.29

19.82

14.93

11.26

8.48

6.39

4.82

3.63

2.74

335.27

252.67

190.42

143.51

108.15

81.51

61.43

46.29

34.89

2.06

1.55

1.17

0.88

0.67

0.50

0.38

Asset

108.15

81.51

61.43

46.29

34.89

26.29

19.82

14.93

11.26

8.48

6.39

Fully

Diluted Per

Share

13.18

9.93

7.49

5.64

4.25

3.20

2.42

1.82

1.37

1.03

0.78

Series A Common

80.54

60.70

45.74

34.47

28.57

22.17

17.35

13.71

10.97

8.48

6.39

27.61

20.81

15.68

11.82

6.32

4.12

2.47

1.22

0.28

0.00

0.00



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

39



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

40



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)

41



Comparison of Latest Round Results

Original

Issue Price

Based on

Series A Price

EV

Based on Pre-

Money Term

Sheet EV

42

Series A Preferred Stock

Common

Total

$ 1.6600

$ -

• Preferred priced at 19% premium on "day 2"

• Common priced at 43% premium

$ 1.66

$ 0.53

$ 1.37

$ 1.97

$ 0.76

$ 1.66



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

43



A Few Caveats About Using the

Practice Aid

44



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



How to Adjust for Future Levels of Cash and Debt

• Estimate future use or generation of cash?

• Amortize debt?

• Factor in option proceeds?

46



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?

47



Application of Minority Interest Discounts

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

48



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?

49



How to Handle the Discount for

Lack of Control (DLOC) and the

Discount for Lack of

Marketability (DLOM)

50



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)

51



52

How to Handle DLOC and DLOM

Interests of Preferred Stockholders Compared with Common

 Fair value below liquidation preference

Less Aligned

 Fair value is between the liquidation preference of preferred, but less than the conversion price in nonparticipating preferred

 No automatic conversion, significantly below automatic conversion price or transaction type does not require conversion

 Additional financing rounds required; resulting in disproportionate dilution to common

More Aligned

 Significant fair value above liquidation preference

 Fair value is above conversion threshold of non-participating preferred





Automatic conversion, likely scenario is IPO with automatic conversion

No additional financing necessary



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

53



Quantitative Models Seen Used

• Restricted stock regression analysis (i.e., Longstaff)

• Put option

• Put-call collar

• Proprietary models

54



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, doesn’t reflect present value impact of receiving a specified price in the future

• Proprietary models cannot be audited

55



Tips for Producing a Report

That Satisfies Both Goals: Tax and Financial Reporting

56



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?

57



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

58



Questions?

• Email tc-questions@bvresources.com

at any time during the Teleconference

• The conference operator will provide instructions on how to ask live questions

59



Thank You for Attending!

• Visit www.bvresources.com/conferences for a schedule of exciting upcoming sessions, as always, Teleconferences are good for two CPE credits

• May 23 rd , Playing and Prospering By the New Valuation Rules featuring Al King and Matt

Crow

• May 24 th , Overview of Buy-Sell Agreements (part 1 of 3) featuring Chris Mercer

• May 31 st , Lost Profit Damages featuring Nancy Fannon, Robert Gray and Thomas Burrage

• June 14 th , Application of Buy-Sell Agreements (part 2 of 3) featuring Chris Mercer

• June 26 th , Recruiting in the BV Profession featuring Jim Alerding, Megan Nail and Ron

Seigneur

• June 28 th , ESOP Valuation featuring moderator Robert Reilly

• July 19 th , Buy-Sell Agreements and Valuation Related Issues (part 3 of 3) featuring Chris

Mercer

• July 25 th , Electronic Discovery featuring Ron Seigneur, Melinda Harper and Shari Lutz

60



CPE Credits

• All BVR Teleconferences are worth two interactive CPE credits

• Be sure to complete the post-conference survey within five business days: http://www.bvresources.com/defaulttextonly.asp?f=tcsurvey050207

• You should receive your CPE certificate via email within one week

61

Business Valuation Resources

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1-888-BUS-VALU (287-8258) / Fax: 503-291-7955 www.bvresources.com

info@bvresources.com



Valuing Intangible Assets for Financial Reporting

409A Compliance –

Issues, Approaches and

Mistakes Not to Make

What is 409A?

What are the Characteristics of a Typical 409A Client?

Who is the Audience for a

409A Appraisal?

What Guidance and

Regulations Apply to a 409A

Appraisal?

How Does Fair Market Value

Compare to Fair Value?

The AICPA Practice Aid

How to Handle the Price Paid for Preferred Shares

A Few Caveats About Using the

Practice Aid

How to Handle the Discount for

Lack of Control (DLOC) and the

Discount for Lack of

Marketability (DLOM)

Tips for Producing a Report

That Satisfies Both Goals: Tax and Financial Reporting

Related documents

Products

Support

Valuing Intangible Assets for Financial Reporting

409A Compliance –

Issues, Approaches and

Mistakes Not to Make

What is 409A?

What are the Characteristics of a Typical 409A Client?

Who is the Audience for a

409A Appraisal?

What Guidance and

Regulations Apply to a 409A

Appraisal?

How Does Fair Market Value

Compare to Fair Value?

The AICPA Practice Aid

How to Handle the Price Paid for Preferred Shares

A Few Caveats About Using the

Practice Aid

How to Handle the Discount for

Lack of Control (DLOC) and the

Discount for Lack of

Marketability (DLOM)

Tips for Producing a Report

That Satisfies Both Goals: Tax and Financial Reporting

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