Stock Options Under Section 409A

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					Stock Options Under Section 409A

                        Panelists:
     Ralph Barry - Wilson Sonsini Goodrich & Rosati
           Jeffrey Kinderman – Oracle Capital
         David Russian - CFO & Entrepreneur
                            .
                       Moderator:
          Bill Dunn, PricewaterhouseCoopers


                   September 16, 2009
                       Agenda

•    Quick Recap of 409A generally
•    How does is apply to stock options?
•    Educating the stakeholders
•    Dealing with the Section 409A valuation requirements
•    Lessons from the IRS
•    Wrap-up
  What is Section 409A Generally?

•  In response to perceived abuses in the area of deferred
   compensation, the American Jobs Creation Act of 2004 enacted
   Section 409A
         •  Applies to nonqualified deferred compensation that is
            earned and vested after December 31, 2004.
•  Section 409A requires that nonqualified deferred compensation
   plans meet specific design and administration requirements.
•  If the plan’s document fails the requirements of Section 409A,
   then upon vesting, all participants are subject to tax on the
   deferred compensation balance plus an additional 20% tax plus
   interest charges.
How Does Section 409A Apply to Stock
             Options?
•  Stock options issued (i) with exercise prices less than
   fair market value on the date of grant, or (ii) which are
   not based on “common stock” are considered
   deferred compensation.
•  Stock options granted prior to 10/3/2004 and vested
   by 12/31/2004 are not subject to Section 409A.
•  Incentive stock options are generally exempt.
     Adverse Tax Consequences

•  Taxation at time of option vesting, not date of
   exercise.
•  Additional federal tax of 20% and an additional 20%
   California tax on the optionee on top of regular
   income taxes.
•  Potential interest penalty calculated at the
   underpayment rate plus 1%.
•  Employers have reporting and withholding
   requirements at the time of option vesting.
        Incentive Stock Options
•  Generally exempt from Section 409A.
•  Board’s good faith determination of fair market
   value should still be respected for incentive stock
   option purposes.
•  But because of Section 409A, the IRS has a
   greater incentive to question determinations.
•  Also important to follow the nonstatutory option
   valuation rules if nonstatutory options are granted
   at the same time.
          Nonstatutory Stock Options
        Private Company Option Pricing

•  Strict rules related to valuation of private company stock.
•  Choice of valuation method determines who has the
   burden of proof:
    –  If pricing is done pursuant to presumptions in the final
       regulations, IRS must prove that valuation was “grossly
       unreasonable”.
    –  If pricing was not done pursuant to presumptions,
       taxpayer has the burden of proving that valuation was
       reasonable.
   Reasonable Valuation Method
             Factors
•  The factors to be considered under a reasonable
   valuation method include, as applicable:
    –  The value of tangible and intangible assets;
    –  The present value of future cash-flows;
    –  The readily determinable market value of similar
       entities engaged in a substantially similar
       business;
    –  Recent arm’s length transactions involving the
       sale or transfer of stock; and
    –  Other relevant factors (e.g., control premiums or
       discounts for lack of marketability).
     Private Company Valuation
            Presumptions
•  Independent appraisal
•  Binding formula
•  Good-faith written report
          Independent Appraisal

•  Independence rules are strict (used for Employee
   Stock Ownership Plans and private foundations)
•  Appraisal report needs to include appropriate recitals
•  Can be relied upon for up to 12 months, but not after
   the occurrence of a material event affecting value of
   company
               Binding formula

•  Value based on buy back formula used
•  Must be used for all compensatory and non-
   compensatory purposes
•  Would be treated as the fair market value under
   Section 83
     Illiquid Stock of Startup Corporation—
            Good-Faith Written Report
•    The presumption for illiquid stock of a startup corporation requires:
     –  The company has conducted trade/business for less than
        10 years and has no publicly traded securities;
     –  The valuation is evidenced by a written report;
     –  The valuation takes into account the Reasonable
        Valuation Method Factors previously described.
     –  The valuation is performed by a person with significant
        knowledge and experience or training in performing
        similar valuations; and
     –  The company does not reasonably anticipate an IPO
        within 6 months or a change in control within 3 months
        following the date to which the valuation applies.
          Modification of Options

•  A modification occurs when there’s been a direct or
   indirect resolution of the exercise price
    –  Extensions receive slightly different treatment (see
       below for further information)
•  A modification results in a deemed new grant and must
   determine whether it results in option becoming subject to
   Section 409A
               Extension of Options
•  An extension occurs when:
    –  The right to exercise a stock right is extended beyond its original term,
    –  A stock right is exchanged for a right to receive compensation in a future
       year, or
    –  A right to defer compensation beyond the date of exercise is added to the
       award.
•  Extension of post-termination exercise period to end of original
   term is permitted (but not beyond 10-year anniversary of grant
   date)
•  Extension permitted where exercise would violate applicable
   laws or ability to continue as a going concern
•  Result of an extension is that stock right is treated as having a
   deferral feature from its original date of grant
•  Broad exemption for extensions before April 10, 2007
      Board of Directors Liability

•  Potential penalties as “responsible person” for
   underwithholding of income tax if Company does not
   meet obligations.
•  Potential individual lawsuit if an employee is
   subjected to higher tax liability as a result of improper
   price setting.
      Recommendations for Option
             Valuations
•  Attempt to satisfy one of the presumptions,
   particularly the written report made reasonably and in
   good faith
   –  Can a director, company employee or advisor satisfy
      the “significant knowledge and experience or training”
      requirement?
•  Short of satisfying presumption, prepare internal
   valuation based upon specified general valuation
   factors set forth above
Impact on the Stakeholders
     Educating Board & Officers
•  May not have heard of 409a (foreign
   investors)
•  Impacts stock options but also EPS (FAS
   123R)
•  Can be costly, Independent accountant &
   valuation fees can be high.
•  409a impacts all deferred comp. Example:
   bonuses, severance, SERPs.
•  Anticipate valuation surprises.
             Company Process
•  Board approval to grant stock options and obtain a
   valuation for common stock.

•  Ensure independent accountants are part of the
   selection process of a valuation team.

•  Get early buy-in between valuation team and
   auditors on approach and timing. Auditors may want
   more than one valuation per year.

•  Auditors prefer stock options issued close to
   valuation date
             Company Process

•  Management Forecasts:
   –  Valuation team will ask for more years than you
      would expect.
   –  Use recent long term strategic plans if available to
      build in “Consistency” of forecasts.
   –  Get Division Presidents, Vice President of Sales
      involved.
   –  CEO and board approval
Valuing Privately Held Equity
    Securities Issued As
       Compensation
              Enterprise Valuation
                   Fair Value vs. Fair Market Value

  Fair Market Value Definition
      IRS Definition - “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.”
  Fair Value Definition
      Statement of Financial Accounting Standards No. 157 - “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.”
        Enterprise Valuation
                Factors to Consider

 The nature of the business and the history of the
  enterprise from its inception
 The economic outlook in general and the condition
  and outlook of the specific industry in particular
 The book value of the stock and the financial
  condition of the business
 The earning capacity of the Company
       Enterprise Valuation
                Factors to Consider

 The dividend-paying capacity
 Whether or not the enterprise has goodwill or
  other intangible value
 Sales of the stock and the size of the block of
  stock to be valued
 The market price of stocks of corporations
  engaged in the same or a similar line of business
  having their stocks actively traded in a free and
  open market, either on an exchange or over the
  counter
          Enterprise Valuation
                     The Approaches


  Cost Approach


  Market Approach


  Income Approach
           Enterprise Valuation
                    The Cost Approach

  Cost Approach– The cost approach places primary
   emphasis on the value of the assets and liabilities of
   the company by revaluing each of the assets and
   liabilities of a business to the values that could be
   realized upon a sale to a disinterested third party.
   The cost approach is an appropriate method used for
   holding companies, or companies with no established
   earnings history. This approach is useful when the
   majority of revenues are derived from tangible assets
   with little emphasis on labor. Generally considered
   the weakest of the three methods.
            Enterprise Valuation
                    The Market Approach


  Market Approach – a general way of determining a
   value indication of a business, business ownership
   interest, security, or intangible asset by using one or
   more methods that compare the subject to similar
   businesses, business ownership interests, securities,
   or intangible assets that have been sold.
  Basic Premise – principle of substitution – a prudent
   buyer will pay no more for a property than it would
   cost to acquire a substitute property with similar
   utility.
               Enterprise Valuation
                         The Market Approach

  Three basic methods
        Prior transactions / investments in subject company
        Guideline Publicly Traded Companies Method (GPTCM)
        Guideline Transaction Method (GTM)
  Strengths and weaknesses of market approach
        Strength - Provides a direct method of valuation
        Strength - Relatively easy to get data
          Strength - Lots of information and research on public
        companies
        Weakness - Very difficult to find truly similar companies
           Enterprise Valuation
                  The Income Approach

  Income Approach – a general way of determining a
   value indication of a business, business ownership
   interest, or intangible asset by focusing on the
   income-producing capability of an asset/business.
   This valuation is based on the expected economic
   after-tax income stream of an asset or business over
   the estimated life of the asset or business.
  Basic Premise – present value of future economic
   income stream – which can be net income, net cash
   flow to equity owners, net cash flow to debt and
   equity owners, etc.
             Enterprise Valuation
                   The Income Approach

  Two basic methods used for a business valuation
     Capitalization of Earnings Method
     Discounted Future Earnings Method
  Strengths and weaknesses of income approach
     Strength - Data is company specific
           Weakness - Nobody has a crystal ball and
        discount rate is subjective
           Enterprise Valuation
             The Most Commonly Used Methods

  Guideline Publicly Traded Companies Method


  Guideline Transactions Method


  Recent Investment in Subject Company


  Discounted Future Earnings Method
    Allocation of Enterprise Value
                              Why so Difficult?

  Many, if not most, of all start-up enterprises are financed by a
   combination of different equity securities (generally lumped into
   two broad categories, preferred and common), each providing
   its holders with various rights, privileges, and preferences.
   Oftentimes, there are many successive rounds of preferred
   equities each with differing rights. Some of these rights may
   include:
      Liquidation preferences
      Redemption rights
      Conversion rights
      Voting rights
      Anti-dilution rights
   Allocation of Enterprise Value
              Three Commonly Used Methods

  Probability-Weighted   Expected    Return   Method
   (PWERM)


  Option-Pricing Method (OPM)


  Current-Value Method
   Allocation of Enterprise Value
                 One Unacceptable Method

  Using rule-of-thumb discounts to derive the value of
   the common stock from the prices of recent rounds of
   preferred stock are not acceptable in terms of
   providing reasonable and supportable determinations
   of fair value or fair market value.


  As an example, the most recent round of preferred
   stock sold for $2.00 per share, therefore the common
   stock should be worth 15% of the preferred or $0.30.
   Allocation of Enterprise Value
         Probability-Weighted Expected Return Method

  PWERM – the value of the common stock is
   estimated based on an analysis of future values for
   the company assuming various exit scenarios. Share
   value is based on the probability-weighted present
   value of the expected future outcomes considering
   the rights and preferences to each class of
   shareholder assuming each class of shareholder will
   seek to maximize their outcome.
    Allocation of Enterprise Value
           Probability-Weighted Expected Return Method

  The primary strengths of this method are:
      Forward-looking assumptions
      Conceptually easy to understand
      Considers the various rights of each class
      Considers a variety of exit scenarios and dates
  The primary weakness of this method are:
      May be complex to implement
      Requires numerous assumptions about potential future
       outcomes
      Estimates of required outcomes may be difficult to support
    Allocation of Enterprise Value
                    Option-Pricing Method

  OPM – the value of the common stock is equivalent
   to a call option on any value of a company above the
   respective     preferred     shareholders     liquidation
   preferences, with an adjustment to account for the
   rights retained by the preferred shareholders related
   to their portion of any value above the values at
   which they would convert to common shares. Thus,
   the value of the common stock can be valued by
   estimating the value of its portion of each of these call
   option rights.
    Allocation of Enterprise Value
                       Option-Pricing Method

  The primary strengths of this method are:
      Implicitly considers liquidation preferences as of future
       liquidation date
      Highly applicable when range of future possible outcomes is
       hard to predict
      Works well in both a top-down and bottom-up approach
  The primary weakness of this method are:
      Is complex to implement and understand
      Is sensitive to key assumptions such as volatility
   Allocation of Enterprise Value
           Option-Pricing Method – Two Examples

  Example 1 – top-down approach.         No recent
   transactions in subject company stock. Determine
   enterprise value through traditional valuation
   methodologies.


  Example 2 – bottom-up approach.            Recent
   transaction in subject company stock at $2.80 per
   share for preferred series E stock.
    Allocation of Enterprise Value
                   Current-Value Method

  Current-value method – the value of the common
   stock is determined by allocating the current value of
   the company, as determined by one of the common
   enterprise valuation methods, using a waterfall
   method. This methodology is to be used in two very
   limited circumstances; 1) the company has no real
   business plan or has made no progress on
   implementing its business plan, and 2) no reasonable
   basis for determining timing of common equity value
   above liquidation preferences.
    Allocation of Enterprise Value
                       Current-Value Method

  The primary strengths of this method are:
      Easy to understand and implement
      Does not require the use of complex or proprietary methods
  The primary weakness of this method are:
      Does not consider the potential future value of the company
      Highly sensitive to changes in assumptions
      Oftentimes, this methodology does not allocate any value to
       the common stock
                Wrapping-it-Up

  Bring your auditor into the process early.


  While the company may solicit recommendations
   from its auditors and legal counsel, it is the
   responsibility of company management to properly
   vet and select a qualified appraiser.


  The options you issue will have both tax, 409(A), and
   financial statement, SFAS 123(R), implications.
                Wrapping-it-Up

  Your auditor, and possibly your legal counsel, will
   want to be involved in reviewing your outside
   appraiser’s work and will most likely have significant
   questions    involving    selection    of   valuation
   methodology and assumptions utilized.


  This is not a quick or easy process, so leave ample
   time (six to eight weeks) to complete the analysis.
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