CEO Compensation in Private Venture-Backed Firms

[twocol_one]
Ola Bengtsson
Johnson School
Cornell University
Ithaca, NY 14853-6201
Tel.: 607.254.8807
lob2@cornell.edu
[/twocol_one]
[twocol_one_last]
John R. M. Hand
Kenan-Flagler Business School
UNC Chapel Hill
Chapel Hill, NC 27599-3490
Tel.: 919.962.3173
hand@unc.edu
[/twocol_one_last]

We study the pay earned by CEOs during the early life-stages of private venture-backed firms. The typical venture-backed startup needs considerable external financing to survive and flourish, but faces illiquid and informationally opaque capital markets. This makes fundraising a vital but difficult CEO task. We therefore expect that CEO compensation will be linked to how successfully the firm raises capital. Using a new compensation database on 1,585 U.S. venture- backed firms, we show that CEO cash pay is indeed higher for companies that have recently raised more equity, and that have attracted more experienced VCs. We argue that the observed elasticity on fundraising is unlikely to simply reflect differences in firm size because it is robust to controls for firm characteristics, firm operating performance, and firm valuation. CEO cash pay is also larger when fundraising is more difficult, and is smaller for executives who are not involved in fundraising. In the time-series, CEO cash pay increases markedly in the year after a financing and increases more if the company raised more capital. Finally, we show that while successful fundraising dilutes the CEO’s percentage ownership, it increases the dollar value of that ownership. Our findings suggest that cash and equity compensation help align CEO incentives even when sophisticated investors such as VCs are active monitors and hold strong control rights.

JEL classifications:    J33, M13, M52.

Keywords:   CEO compensation; financing; pay-for-performance; private venture-backed firms.

Read full publication.

Preferred Stock Valuation Issues

In general the most important factors to be considered in determining the value of preferred stock are:

  • The stock’s yield rate,
  • Dividend coverage ratio, and
  • Protection of its liquidation preference.

In addition, the appraiser has to assess the preferred stock voting rights, redemption privileges, and discounts for lack of marketability if the preferred stock is not publicly traded.

Preferred Stock Dividend Yield

Whether the yield of the preferred stock supports a valuation of the stock at par value depends in part on the adequacy of the dividend rate. The adequacy of the dividend rate should be determined by comparing its dividend rate of the preferred stock with the dividend rate of high-grade publicly traded preferred stock. A lower yield than that of high-grade preferred stock indicates a preferred stock value of less than par. If the rate of interest charged by independent creditors to the corporation on loans is higher than the rate such independent creditors charge their most credit worthy borrowers, then the yield on the preferred stock should be correspondingly higher than the yield on high quality preferred stock.

A yield which is not correspondingly higher reduces the value of the preferred stock. In addition, whether the preferred stock has a fixed dividend rate and is non-participating influences the value of the preferred stock. A publicly traded preferred stock for a company having a similar business and similar assets with similar liquidation preferences, voting rights and other similar terms would be the ideal comparable for determining yield required in arm’s-length transactions for closely held preferred stock. Such ideal comparables will frequently not exist. In such circumstances, the most comparable publicly traded issues should be selected for comparison and appropriate adjustments made for differing factors.

Dividend Coverage Ratio

The actual dividend rate on preferred stock can be assumed to be its stated rate if the issuing corporation will be able to pay its stated dividends in a timely manner and will, in fact, pay such dividends. The risk that the corporation may be unable to timely pay the stated dividends on the preferred stock can be measured by the coverage of such dividends by the corporation’s earnings. Coverage of the dividends or dividend coverage ratio is measured by the ratio of the sum of the pre-tax and pre-interest earnings to the sum of the total interest to be paid and the pre-tax earnings needed to pay the pre-tax dividends. Standard & Poor’s Rating Guide, 58 (1979).

Inadequate coverage exists where a decline in corporate profits would be likely to jeopardize the corporation’s ability to pay dividends on the preferred stock. The ratio of the preferred stock in question should be compared with the ratios of high quality preferred stock to determine whether the preferred stock has adequate coverage. Prior earnings history is important in this determination. Inadequate coverage indicates that the value of the preferred stock is lower than its par value.  Moreover, the absence of the provision that the preferred dividends are cumulative raises substantial questions concerning whether the stated dividend rate will be paid. Accordingly, preferred stock with non-cumulative dividend features will normally have a value substantially lower than a cumulative preferred stock with the same yield, liquidation preference and dividend coverage.

Preferred Stock Liquidation Preference

Whether the issuing corporation will be able to pay the full liquidation preference at liquidation must be taken into account in determining the fair market. This risk can be measured by the protection afforded by the corporation’s net assets. Such protection can be measured by the ratio of the excess of the current market value of the corporation’s assets over the liabilities to the aggregate liquidation preference. The protection ratio should be compared with the ratios for high quality preferred stock to determine adequacy of coverage. Inadequate asset protection exists where any unforeseen business reverses would be likely to jeopardize the corporation’s ability to pay the full liquidation preference to the holders of the preferred stock.

Preferred Stock Voting Rights

Another factor to be considered in valuing the preferred stock is whether it has voting rights and, if so, whether the preferred stock has voting control. Typically preferred stock is non-voting stock and can exert no control of the Company in most profitable operating circumstances. In certain circumstances, where the Company’s value has been impaired due to poor financial operating performance, preferred stock shareholder agreements provide feature whereby the preferred shareholders can vote on management and operational decision making, according to the preferred shareholder agreement.

If the preferred stock shareholder’s agreement has provisions for voting control under certain circumstances, these provisions could under certain circumstances increase the value of the preferred stock and reduce the value of the common stock. If the preferred stock has voting rights, but cannot exert control, the stock may be subject to a minority interest discount for valuation purposes as compared to a controlling block of preferred stock.

The equity coverage factor provides a protection right to the preferred shareholders over the common stockholders in respect to the payment of dividends. The voting rights factor provides another protection right to the preferred shareholders by allowing the holders to vote as a class on the operations of the Company if the equity coverage falls below the preferred shares’ liquidation preference value. In situations where the preferred shareholder’s equity coverage, and the liquidation preference value minimums have not been triggered, the preferred shareholders have no voting rights, and therefore a minority interest discount is appropriate as it reflects the inability of the preferred shareholders to compel liquidation, effect a distribution of equity ownership, or exert any of the elements of absolute business ownership control, and/or thereby realize a pro rata share of the Company’s net asset value.

Minority Interest Discount

A minority interest discount is a reduction in the control value of the appraisal subject that is intended to reflect the fact that a minority stockholder cannot control the daily activities or policy decisions of a business enterprise, especially under financially distressed circumstances, thus reducing its value. The size of the discount will depend on the size of the interest being appraised, the amount of control, the stockholder’s ability to liquidate the company, and other factors.  A minority interest discount is basically the opposite of a control premium for control. This type  of discount is used to obtain the value of non-controlling interest in the appraisal subject, when a control value is the starting point. Conversely, a control premium is used to determine the control value when the freely traded minority value is the starting point.  The starting point is determined based on the method of valuation, the normalization adjustments made, and the source of the discount or capitalization rates. Minority discounts can be mathematically determined using control premiums that are measured in the public market. The formula to determine the minority interest is as follows: [1-(1/1.0 + Control Premium)]. One of the more common sources of information used to measure the discount is MergerStat Review. MergerStat Review always uses public price of the stock five days prior to a takeover announcement. The benefit of this method is that it is consistent and objective way of measuring the premium or discount. The draw back of this method is that based on rumors of a deal, the public price may have already started to climb, which thus understates the premium.

While the determination of a minority interest discount is highly subjective, recent research on the market for corporate control provides some guidance.  MergerStat  compiles statistics on publicly-announced mergers, acquisition, and divestitures.  The statistics provide a trend in prices, methods of payment and other financial data.  Mergerstat provides statistics of the premium paid for control and the implied minority interest discount for lack of control by industry classification. Mergerstat determines control premiums paid in consummated merger and acquisition transactions. The survey is arrayed by industry SIC code, and transaction size, etc.

The inverse of the control premium as noted above is the minority interest discount. Based on  Mergerstat observed control premiums a minority interest discount can be determined utilizing the following formula: [1- (1/(1+control premium)].

According to MergerStat “A control premium is defined as the additional consideration  that an investor would pay over a marketable minority equity value (current, publicly traded stock price) in order to own a controlling interest in the stock of a company.”  In the MergerStat studies, the premium is expressed as a percentage of the unaffected marketable minority price per share. This is the price just prior to the point of change in the representative normal pricing of a given security. A minority interest is by definition control of less than 50% of the shares of a company.  This lack of control results in a shareholder being unable to appoint management, set company compensation levels, determine dividends, set company policy, sell the company, etc.  This lack of control can result in a minority interest discount.

The comparable industries include agricultural, mining, construction, manufacturing, transportation, commercial, electric and gas, wholesale, retail, financial services, and general services. The size of transactions are millions to billions of dollars.

Peculiar covenants or provisions of the preferred stock of a type not ordinarily found in the publicly traded preferred stock should be carefully evaluated to determine the effects of such covenants on the value of the preferred stock. In general, if covenants would inhibit the marketability of the stock or the power of the holder to enforce dividend or liquidation rights, such provisions will reduce the value of the preferred stock by comparison to the value of preferred stock not containing such provisions or covenants.

Preferred Stock Redemption Privileges

Whether the preferred stock contains redemption privilege is another factor to be considered in determining the fair market value of the preferred stock. The value of the redemption privilege triggered by death of the preferred shareholder will not exceed the present value of the redemption premium payable at the preferred shareholder’s death (i.e., the present value of the excess of the redemption price over the fair market value of the preferred stock upon issuance).  The value of the redemption privilege should be reduced to reflect any risk that the corporation may not possess sufficient assets to redeem its preferred stock at the stated redemption price.

Marketability Discounts

Typically, a controlling interest in a company is considered to have greater value than a minority interest because of the holder’s ability to effect change in the overall business structure and to influence business policies.  Marketability adds value to a held security due to the ability that it gives the holder to liquidate their position.  Conversely, lack of marketability detracts from a security’s value.

Marketability refers to an investor’s ability to convert an equity interest to cash with minimal cost and with a high degree of confidence of receiving certain expected proceeds.  The benchmark for minority interest marketability is the U.S. public securities market, whereby an investor can sell a minority equity interest and receive the cash proceeds within three days.

A discount for lack of marketability is normally appropriate for an individual shareholder seeking to sell an interest in a private corporation with no ready market.  An owner of such an interest is subject to the personal objectivity of management as to dividends and the sale of the company as a whole.  Lack of marketability forces an investor to seek a price concession to compensate for being locked into an illiquid and long-term investment.  The concession reflects an investor’s assessment of the length of time that the investment must be held before it can be liquidated, combined with the investment return required and appreciation expected during the holding period.  This forms the basis for a lack of marketability discount.

There are several ways to approach a discount for lack of marketability.  One is to determine flotation costs; i.e., the cost of creating a public market for a security.  In a study[1] by Jay R. Ritter, which  was published in 1987, Mr. Ritter details “The Costs of Going Public” for numerous transactions, where the gross proceeds exceeded $10 million, the total cash expenses to the company involved were 9.34% of proceeds on a firm commitment underwriting basis, and 10.43% on a best-efforts basis.

A second basis for estimating the discount for lack of marketability is to analogize the discount to that obtained by mutual funds in purchasing “letter” stock.  A study[2] by J. Michael Maher published in 1976 indicates that the average discount for the period 1969 through 1973 was 35.4 %.  That figure remained essentially unchanged when the top and bottom 10% of purchases were eliminated to remove extremes of high and low risks.  It may be argued that higher discounts are called for in the case of closely-held stock since mutual fund purchases involved registration rights that were acquired with the stock, and mutual funds sought out only “promising” situations.

In support of the Maher study, the following summary of ten restricted stock studies, covering a 27-year period from 1966-1992, indicates an average discount of 32.9%. More importantly, 7 of the 10 studies found averages between 31% and 36%.

 

 

Summary of Restricted Stock Studies

 

 

 

 

Study

 

Years

Covered

in Study

 

 

Average

Discount (%)

 

SEC Overall AverageSEC Nonreporting OTC CompaniesGelmanTroutMoroneyMaherStandard Research ConsultantsWillamette Management Associates

Silber

FMV Opinions, Inc.

 

Average

 

1966-69

1966-69

1968-70

1968-72

1972-73

1969-73

1978-82

1982-84

1981-88

1972-1992

25.8

32.6

33.0

33.5

35.6

35.4

45.0

31.2

33.8

23.0

 

32.9

The first study[3] was the SEC Institutional Investor Study published in 1971.  It examined more than 300 transactions involving restricted stocks and compared the prices to prices of stock identical except for trading restrictions.  The study found an average discount of 25.8%.  For stocks that would trade on the over-the-counter market rather than the New York Stock Exchange or American Stock Exchange, the average discount was 32.6%.  This suggests that smaller companies incur a higher discount than their larger counterparts.

Another relevant approach is reviewing the price relationship of stock transactions occurring within several of a subsequent initial public offering (“IPO”) of the same stock.  The offering prospectus filed with the Securities and Exchange Commission (“SEC”) is obligated to identify stock transactions and prices among insiders within the previous years.  The most recent study[4] indicates that the median discount for 91 transactions during the period of 18 months from November 1995 through April 1997 was 42%.  In previous similar studies over a period of 18 years, the average median discount was 42%.

The following table summarizes the findings of the eight periods studied:

 

The Value of Marketability as Illustrated in Initial Public Offerings of Common Stock

 

Study

No. of IPO

Prospectuses

Reviewed

No. of

Qualifying

Transactions

Discount

Mean %

Discount

Median %

 

1980-81

1985-86

1987-89

1989-90

1990-92

1991-93

1994-95

1995-97

   97

 130

   98

 157

 266

 443

 318

 732

 

2,241

13

21

27

23

35

54

46

91

 

310

60

43

45

45

42

45

45

43

 

44

66

43

45

40

40

44

45

42

 

43

The various cited studies suggest a consistent range of marketability discounts for restricted securities and unregistered pre-IPO securities from 25% to 45% over a period covering more than 30 years.

More recently, data is available from a study prepared by Houlihan Valuation, which analyzed private placements of restricted stock in the period from 1980 through 1991.  In this study, 77 private placement transactions involving restricted stock of publicly traded companies were analyzed.  The discounts from freely traded market prices of these securities varied significantly, ranging from a premium of 6% to a discount of 72% and a median discount of 24%.

In general, companies with larger annual revenues exhibited lower discounts as indicated by the median discounts by quartile, summarized as follows:

Marketability Discount Relative to Revenues

 

 

Annual Revenue

(Millions $)

 

Median

Discounts

1st Quartile

2nd Quartile

3rd Quartile

4th Quartile

 

48  to 527

  8  to   48

  4  to   15

  0  to     3

 

16%

17%

24%

42%

It should be noted that the Houlihan study involved transactions of securities that will be marketable when Rule 144 restrictions expire.  Whereas closely-held stock of private companies generally have no imminent prospects for marketability, as such they are considered less liquid and likely to result in a higher discount.

The appraiser needs to consider the Company ‘s operating history, trend in revenue, plans for profitability, and cash flow in relation to the various available data on marketability discounts.  The appraiser also needs to considered the fact that there may be key employees who could certainly detract from the marketability of a minority interest.  This opinion was based primarily on the SEC Institutional Investor Study of the over-the-counter market, as the company , can most closely resemble this type of security and, in fact, all of the comparable companies selected currently trade on this basis.

 

By Ronald J. Adams, CPA, CVA, ABV, CBA, CFF, FVS, CGMA

Sources:

  1. Understanding Business Valuation, A Practical Guide to Valuing Small to Medium-sized Businesses, by Gary R. Trugman, published by the American Institute of Certified Public Accountants (AICPA),  1998, New York, NY , pp. 528-530, pp. 265-267
  2. Merger Stat 2013 Control Premium Study .

For a consultation, please call Ronald Adams, CPA, CVA, ABV, CBA, CFF, CGMA, Managing Director – Valuations, Foxboro Consulting Group, Inc. at (774) 719-2236; or on my cell at: (508) 878-8390; or by e-mail at: adams.r@foxboro-consulting.com. On the web at: www.foxboro-consulting.com



[1] Jay R. Ritter, “The Costs of Going Public,” Journal of Financial Economics, January 1987, p. 272.

[2] J. Michael Maher, “Discounts for Lack of Marketability for Closely-Held Business Interests,” page 54, Taxes – The Tax Magazine 562 (1976).

[3] “Discounts Involved in Purchase of Common Stock (1966-1992),” “Institutional Investor Study Report of the Securities and Exchange commission,” H.R. Doc No. 64, Part 5, 92nd Cong. 1st Sess. 2444-2456 (1971).

[4] Emory, John D., “The Value of Marketability as Illustrated in Initial Public Offerings of Common Stock – November 1995 through April 1997,” Business Valuation Review, Vol. 16, No. 3, September 1997.

Business Valuation – A Tool to Assess Business Ownership Transition Options

Business owners will find themselves evaluating various ownership transfer options for their companies, especially as they near those golden years.  Wise owners have planned for the transition of their businesses from the first day they stated their businesses.

Appropriate planning, well in advance of any contemplated transaction, will enable business owners to maximize overall company performance, as well as the rate of return on their investment. However, in reality, most business owners exit their businesses with less than six months of advanced planning. In addition, children of business owners are less likely to take over the family business, and they are facing little pressure from their parents to do so. Approximately one third (1/3) of family businesses are successfully transferred to the next generation, and a mere 13 percent are passed on to the third generation.  Typical ownership transfer options usually take the following forms:

  1. Outright sale of the company to a third party;
  2. Sale of the company to key management via a leveraged buy-out;
  3. Buy/Sell of equity ownership interests between partners, shareholders, and member’s ownership interests (partnership units, common stock/shares, member units),
  4. Transfer of minority ownership interests in company stock to family members utilizing estate tax planning strategies and mechanisms such as grantor retained annuity trusts (GRATs), family limited partnerships (FLPs), etc.;
  5. Sale of a minority ownership interest in the company to an equity investor;
  6. Issuance of stock appreciation rights (SARs), phantom stock, or stock options to key management members utilizing qualified and non-qualified stock options;
  7. Transfer of business to charitable trust, while benefiting from charitable giving, including charitable remainder trust (CRT), charitable lead trust (CLT), charitable lead annuity trust (CLAT), or charitable lead   unitrust  interest (CLUT), etc.;  and
  8. Transfer of ownership interests in the company by means of an employee stock ownership plan (ESOP). 

The Need for Business Valuation To analyze the ownership transfer option

Transfer of Business Ownership Options

Depending on the motivations for transferring control or minority ownership of the business, the valuation of the business will yield a range of valuation results. For example, the transfer of a minority interest in the business to employees via an employee stock ownership plan (ESOP), or gifting stock to family members for estate planning purposes through a grantor retained annuity trust (GRAT) or family limited partnership (FLP), or issuing stock options or stock appreciation rights (SARs) to incentivize key management members will usually be determined at “fair market value”. Internal Revenue Service (IRS) Regulations define 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”.

Business owners motivated to sell to the Company’s management team or other outside interested parties will need to determine the Company’s  “investment value”, or the value to a specific investor, which is defined as:

Investment value is the value of an asset or business to a specific owner or prospective owner. Accordingly, this type of value considers the owner’s or prospective owner’s knowledge, abilities, expectations of risk and earning potential, revenue and cost synergies, and other factors.

An example of investment value is when a transaction provides unique motivators or synergies to a particular buyer that is unavailable to the typical buyer.  In this situation, the transaction usually includes a synergistic or acquisition premium that reflects additional value to a particular buyer.

In the sale of the company or any ownership buy-out transaction, a business valuation is crucial information that will provide the business owner with the most leverage during the sale or any ownership transfer negotiation process.

FOXBORO CONSULTING GROUP’s ENTERPRISE VALUATION REVIEW (“EVR”) – AN  ANALYTICAL  VALUATION TOOL

Foxboro Consulting Group has developed the business Enterprise Valuation Review (EVR) to assist a business owner determine the value of their Company under various circumstances based on the business owner’s transfer motivations and liquidity goals.

Through the utilization of the  EVR, a business owner’s motivation and purpose for transferring part or all of the business ownership interest is valued. A wide variety of transfer motives often leads to a correspondingly broad range of potential values for a business.

As part of our methodology, we utilize the income approach, market approach, asset approaches to business valuation. These valuation approaches are described as follows:

Income Approach

The income approach, as applied using the discounted cash flow (“DCF”) method, measures the value of an asset by the present value of its future economic benefits.  These benefits can include earnings, cost savings, tax deductions and proceeds from its disposition.  When applied to equity interests in businesses, value indications are developed by discounting expected cash flows to their present value at a rate of return that incorporates the risk-free rate for the use of funds, the expected rate of inflation and risks associated with the particular investment.  The discount rate selected is generally based on rates of return available from alternative investments of similar type and quality as of the date of value.

Market Approach

The market approach measures the value of an asset through the analysis of recent sales or offerings of comparable property. When applied to the valuation of equity interests, consideration is given to the financial conditions and operating performance of the company being valued relative to those of publicly traded companies operating in the same or similar lines of business, potentially subject to corresponding economic, environmental and political factors and considered to be reasonable investment alternatives. Income statement measures often used to develop pricing measures from guideline companies include the following:

  • Earnings before interest and taxes;
  • Net cash flow;
  • Net income after taxes;
  • Gross cash flow;
  • Gross cash flows before taxes; and,
  • Dividends or dividend-paying capacity.

Cost Approach

The cost approach recognizes that the value of an asset may be represented by the cost to reconstruct or replace it with another of like utility.  To the extent that the utility of the asset appraised is less than that of a new asset, the cost of a new asset may be adjusted to reflect appropriate physical depreciation and functional and economic obsolescence.

Premise of Value

This value indication is appropriate using the premise of value in continued use, as a going concern basis. The reason for this is the public market prices or values stocks on the assumption that they will continue as a going concern.

Foxboro Consulting Group’s Enterprise Valuation Review Complies with IRS Revenue Ruling 59-60

A business valuation should be prepared meeting the requirements of IRS Revenue Ruling 59-60, as one of these ownership transfer options will entail an income tax related event.  Foxboro Consulting Group’s EVR will meet the requirements of Internal Revenue Service (IRS) Revenue Ruling 59-60. The valuation of a company requires an investigation of essential factors affecting fair market value. This investigation will include consideration for the following:

  • The nature of the business, the history of the enterprise and its growth opportunities;
  • The outlook for the general economy and for the industrial fastener industry;
  • The book value of the securities and the financial condition of the business;
  • The historical earnings trend, earnings potential and dividend-paying capacity;
  • The financial history of the Company as reflected in the financial statements for the past five years;
  • The security market history of companies in the same or similar industries, with particular attention given to the ratio of price to sales, equity and earnings;
  • The risk involved in the investment, as related to earnings stability, capital structure, competition and market potential;
  • The marketability of the securities; and,
  • The control characteristics of the current shareholder.

Enterprise Valuation Review Report

In conducting the EVR we would deliver a Complete Appraisal/ Summary Appraisal Report work product and written presentation, which would include a deliverable described as follows:

Discussions with Company management about history, other valuation issues and  expectations about the future,

Consideration of many, but likely use of, and presentation of the actual mechanical        calculations, under two (2) or three (3) approaches to estimate fair value:

Income Approach – Capitalization of Cash Flows Method

Income Approach – Discounted Cash Flow

Market Approach – M & A Transactions Method/Direct Market Data Method, and/or

Market Approach – Guideline Public Company Method, and

Cost/Asset Approach.

Description of the purpose of the valuation procedures, and Standard of Value utilized,

Identity the subject shareholder’s equity ownership interest,

The business interest’s ownership control characteristics, degree of marketability,

Effective valuation date,

Report Date,

Type of report issued (USPAP – “Complete Appraisal/Summary Appraisal Report”)

Assumptions & Limiting  Conditions,

Hypothetical conditions (if any) used in the report will be described.  This includes our querying for, and determining  “normalization adjustments,”

Appraiser Certifications,

If specialist used (probably will not have any) description of how specialist’s work was used, etc.

We would meet with you to discuss our findings and conclusions.

The report would  include the following elements:

  • A letter identifying the fair value of the stockholders’ equity of the Company briefly, as well as the value of the company, and describing the nature and extent of the investigation, and presenting the conclusion(s) reached, a summary of the purpose and scope of the valuation-consulting service, a description of the Company, and the conclusion(s) reached, and
  • Supporting exhibits.

We would be very interested in meeting with you to discuss the particular facts and circumstances of your situation.

We listen, work with, and counsel our clients throughout the process. Our reports document our observations and analysis of your company’s financial performance, its management and ownership structure, its competitive advantages and the industry and economic outlook it faces. We adhere to the Uniform Standards of Professional Appraisal Practice (USPAP) as promulgated by The Appraisal Foundation. Finally, we work diligently with you to ensure that we understand all pertinent facts and circumstances before we arrive at our conclusion of value.

Our valuation reports and analyses have stood up to the highest scrutiny of courts, IRS, other government agencies, and fiduciaries. In short, when you work with us, you’re in good hands.

For an Enterprise Valuation Review consultation, please call Ronald Adams, CPA, CVA, ABV, CBA, CFF, CGMA, Managing Director – Valuations, Foxboro Consulting Group, Inc. at (774) 719-2236; or on my cell at: (508) 878-8390; or by e-mail at: adams.r@foxboro-consulting.com. On the web at: www.foxboro-consulting.com

Interpretation of Employee Stock Option (ESO) Valuation Methodologies

In stock options analysis there are three mainstream methodologies and approaches used to calculate an employee stock option value, these are:

  1. Closed form models like Black–Scholes model, also known as the Black-Scholes-Merton model (“BSM” or “Black-Scholes”), and its modifications such as the Generalized Black-Scholes model (“GBM”);
  1. Monte Carlo Path Dependent Simulation methods; and
  1. Binomial Lattice.

The Black-Scholes model, while theoretically correct and elegant, is insufficient and inappropriately applied when it comes to quantifying the fair market value of employee stock options, this is because the BSM is applicable only to the calculation of European options without dividends, where the holder of the option can exercise the option only on its maturity date and the underlying stock does not pay dividends.

Most employee stock options are American type options with dividends, where the holder can execute the option at any time up to and including the maturity date while the underlying stock pays dividends. In addition, employee stock options have a time to vesting before the employee can execute the option, which may be contingent upon the company/or person attaining a specific performance level (e.g., profitability, growth rate, attain certain sales level, the stock price hitting a minimum barrier before the options become live), and are subject to forfeitures when the employee leaves the company or is terminated prematurely before reaching the vested period. All of these real-life scenarios make the Black-Scholes model insufficient and inappropriate when used to place a fair market value on the stock option grant.

Generally speaking, the Black–Scholes model typically overstates the fair market value of employee stock options where there is sub-optimal early exercise behavior coupled with vesting requirements, and employee forfeitures occur, or when the risk free rates, dividends, and volatilities change over the life of the option. In fact, companies using the Black–Scholes model to value and expense employee stock options may be significantly overstating their true expense, typically incurring hundreds of thousands to tens of millions of dollars in overstated expenses per year.

The Black–Scholes model takes into account only the following inputs: stock price, strike price, time to maturity, a single risk free rate, and a single volatility.  The GBM accounts for the same inputs as well as a single dividend rate.  Hence, in accordance with FAS 123 R requirements, the Black–Scholes model and the GBM fail to account for real life conditions.

The Monte Carlo Path Dependent Simulation Methods are appropriate for complex stock options where the complexity of the option itself makes closed form approached such as Black-Scholes intractable. Rather than solve the differential equations that define the option value in relation to the underlying stock price, a Monte Carlo model determines the value of the option for a set of randomly generated economic scenarios (e.g. future stock prices, option exercise behavior, stock price vs. stock index behavior).  The resulting simulation yields an expected value for the option.

The Binomial Lattice Valuation Methodology can be customized to include the above mentioned input variables plus multiple risk-free rates changing over time, multiple volatilities changing over time, multiple dividend rates changing over time, plus all other real-life factors including but not limited to vesting periods, changing sub-optimal early exercise behaviors, multiple blackout periods, and changing forfeiture rates over time. It is important to note that the customized Binomial Lattice results revert to the GBM if the “real life conditions” are negligible. Therefore, in accordance with FAS 123 (R), which prefers the binomial lattice, we will utilize the customized Binomial Lattice Valuation Methodology to calculate the fair market value of the employee stock options.  It is important to note that valuation results through the use of binomial lattices tend to approach those derived from the closed model solutions, hence we always utilize the BSM and GBM models to benchmark the binomial lattice results. The results from the closed model solutions are typically used in conjunction with the binomial lattice approach when presenting a complete employee stock option valuation solution.   Our valuation will take into consideration many factors that influence the fair market value of stock options including, but not limited to, the following:

  • The stock price;
  • The strike prices;
  • The time to maturity;
  • The risk-free rate;
  • The dividend; and
  • Volatility.

The Binomial Lattice approach will also address the following input items:

  • Time to vesting;
  • Changing forfeiture rate;
  • Changing suboptimal exercise behavior multiples;
  • Black-out dates;
  • Changing risk-free rates;
  • Changing dividends; and
  • Changing volatilities over time.

Foxboro Consulting Group, Inc.’s stock option valuation study will be executed in accordance with practices currently accepted and utilized by the financial and valuation communities and in conformity with the National Association of Certified Valuators & Analysts (NACVA), the American Institute of Certified Public Accountants (AICPA) Statement of Standards for Valuation Services (“SSVS”), The Institute of Business Appraisers (IBA),  and the Uniform Standards of Professional Appraisal Practice (USPAP) promulgated by the Appraisal Standards Board of the Appraisal Foundation, and the Appraisal Standards Board of the Appraisal Foundation.

If you have additional questions or wish to discuss this topic further, you can contact: Ronald J. Adams, CPA, CVA, ABV, CBA, CFF, FVS, CGMA, Managing Director – Valuations,  at (774) 719-2236 – office; or at (508) 878-8390 – mobile; or e-mail him at: adams.r@foxboro-consulting.com .

Start Up Company and Stock Options IRC 83(b)

New ventures go through stages as they progress toward an IPO or acquisition: the start up phase, the angel stage, the venture capital stage, the mezzanine or bridge stage, and finally, the exit event. The exit can take several forms, including an IPO or an acquisition by a publicly held company. During these stages of development, companies
typically issue common stock and stock options to employees.

When stock is issued, taxation is determined under Section 83 of the Internal Revenue Code. The general rule is that the value of the stock is ordinary income when all restrictions on the employee’s ability to receive or resell the stock have lapsed. This could be years after the grant of the stock award if, for example, the employee must work for the company for a few years before he is entitled to keep the stock or resell it. The stock could be nearly worthless now, but worth a significant amount later if the company succeeds.

Legal counsel usually recommends that the employee recipient file what’s known as an “83(b) election.” The election causes the employee to be taxed on the value of the stock when received, instead of later when the restrictions lapse. The value of the stock must be determined in accordance with the rules of that section. These rules generally require that any restrictions on the receipt or resale of the stock be ignored, except a restriction which by its terms will never lapse. Companies are wise to document the value of the stock for
Section 83 purposes with a written valuation report.

Stock options (excluding statutory plan options and ESPP shares) are taxed in accordance with a different set of rules. These rules are known as the “deferred compensation” rules of Section 409A. The rules can cause the inclusion in taxable, ordinary income of the value of the stock, even before exercise, as soon as all risks of forfeiture lapse. Typically, a ten-year option becomes exercisable after two years of continued employment, but the employee waits as long as possible after that before actually exercising. Nevertheless, Section 409A would tax the employee on the value of the stock at the two-year mark when his right to exercise and retain the stock vests. And furthermore, the continuing increase in value of the stock will also be taxed annually. And in addition to that, there is
a 20% tax penalty imposed.

There is an exception to the inclusion rule. If the exercise price of the option is at or above the fair market value of the stock at the date of grant, the stock option is excepted from the Section 409A rules. Thus, for start up companies as well as closely held companies issuing stock options to its employees, it is essential to document the value of
the stock subject to the option.

The company can perform its own value calculation, but if the IRS decides to challenge it, doing so leaves the burden of proof that the result is reasonable on the company. So it becomes an uphill battle from the start. The alternative is to hire a qualified appraiser to perform the valuation. A written appraisal by a qualified appraiser shifts the burden of proof to the IRS. This is an important advantage in the event of an audit.

The value is determined without regard to any restrictions that will lapse. The valuation must take into account the tangible and intangible assets of the company, projected cash flows, similar publicly traded companies, lack of control and lack of marketability, and all other factors affecting the value of the stock. The valuation methodologies used for compliance with generally accepted accounting principals are also applicable to Section
409A compliance.

The valuation is as of a day certain, but is applicable to all stock or option awards granted during the following twelve months, unless there an important event occurs that would affect the value of the company, i.e., another round of financing, achieving first revenue, an IPO, an offer to purchase.

Please contact us to discuss the valuation of your company’s common stock before implementing a stock or stock option award plan. The consequences of not addressing value are too ominous to ignore.

Getting Your Business Ready to Sell

Any good real estate agent will tell you that to get your home ready to sell you need to make improvements to the home’s “curb appeal” as well as fix any obvious flaws on the interior of the home. A selling agent can also provide pointers on how to do a lot of fixes for the least amount of money. For example, a coat of paint is relatively inexpensive but can provide immense returns when the time comes for a potential buyer to make an offer.

Selling a business is a much more complex process. At the risk of over-simplifying the issue, the following are some things to think about if you believe you will be selling your business:

Improve cash flow: A critical review of spending in the months leading up to marketing your business is a necessity. Buyers will want to know how much of the historical cash flow will carry over to them if they were to purchase the company. Normally, they will ask for, or prepare projected cash flows. A clean history assists the seller and buyer in easily determining the true cash flows of the company and, ultimately, cash flow is in many cases what the buyer will be willing to pay for. In other words, you will want to get family members off the payroll, don’t pay for personal expenses through the business, get family cars (and the related loan and insurance payments) and other non-business assets
off the balance sheet, etc.

Due diligence: The process of selling a company will involve “opening up the books” to the prospective buyer-or several potential buyers. Being prepared mentally for this exercise is important. But it is also important to have the relevant documents located and ready. These may include tax returns, historical financial statements, cash flow analysis and projections, business plans, lease agreements, long-term contracts, employment agreements, sales and marketing materials, compensation documentation, etc. And that is just the beginning. Depending on the circumstances of the company being sold there may be extensive site visits and source documentation review by a prospective buyer.

Having everything ready to go improves the “curb appeal” of a business.

Clean accounting: Just as a home should appear neat, clean, and orderly when it is up for sale, so should the accounting records of a business that is being sold. Prospective buyers, or their accountants, should be able to easily review the detail reporting in support of financial statement disclosures. Difficulties in reconciling the financial statements to supporting documentation increase the cost of the transaction and almost always results in a reduced offer price since buyers want to recoup their costs. More importantly, incomplete or haphazard accounting and financial reporting raises the possibility in buyers’ minds that there may be more risk associated with the proposed transaction than they originally thought. Buyers are not willing to pay as much for a riskier investment.

Protection: You should invest in the time of an attorney to guide you through the process. This is particularly true if your business involves trade secrets and/or a highly competitive industry. No prospective buyers should be allowed to roam through your corporate information without signing a non-disclosure agreement.

Know your value: Most home sellers have a very good idea what their home will sell for when they put it on the market. You might be surprised how many business owners attempt to sell their business with no real idea of what their business is worth. If you are contemplating a sale, understand in advance what the business is worth and what the tax ramifications of the sale will be. Retaining a business valuation expert to work with you, your attorney, and your CPA is a wise decision. Not only can the expert assist you in determining a fair price, he or she can alsoassist you in evaluating the taxramifications and the fairness of any offers that come in. You have likelyworked hard to build a business-great care should be taken to assure that the value you have built isunderstood prior to entering the emotion and stress of reviewing an actual offer.

Buy-Sell Agreements Between Business Partners

Businesses are often started by two or more people-with capital and personal effort from each owner. The partners trust each other implicitly and happily share the fruits of their joint undertaking. The business grows and becomes something of value. They envision that they will some day sell the business, retire and remain close friends forever. Unfortunately, things can happen to alter the course of this happy plan. Injury, sickness, disability or death may visit one of the partners. Some may come to believe that one of the partners is no longer pulling his weight. Any number of life’s changing circumstances may lead to one of the partners exiting the business early, either by choice or by force.

By the time these circumstances begin to develop, the aura of camaraderie evident at the formation of the union may have dissipated. Or even worse, the continuing partners suddenly find themselves with a new partner: the estate or widow of their former co-owner. A disagreement arises over the value of the business, the exiting partner’s share of that value, the terms of a buyout, and the right to compete. If only these issues had been dealt with while all the partners were healthy and contributing, there would be a road map to a successful resolution of the matter. They should have had a buy-sell agreement in place.

A well drafted buy-sell agreement will bind the co-owners to its terms. However, great care is needed to insure that it also binds the Internal Revenue Service in the event of a death. Arms length terms and pricing are essential to insure that the IRS accepts the transfer price as the value for the estate.

Imagine yourself on one side of this equation, and then on the other. What is fair and reasonable under each circumstance, and from each point of view? Then begin a dialogue with your partners about what should be done. We can help you design the plan. Here are the basic questions that need to be addressed:

  • What circumstances will activate the buy-sell agreement?
  • What is the current value of the business?
  • How will the value of the business be determined in the future?
  • As of what date will the company be valued?
  • Should the exiting partner receive a pro rata share of the full fair value of the business, or should he receive the fair market value of his minority interest?
  • Will the purchaser be the company or the co-owners?
  • Will the agreement be funded with life insurance, and who will pay the premiums?
  • How much can the company afford to pay up front (with life insurance and without)?
  • What should be the term and interest rate for the balance of the buyout price?
  • How will the deferred portion of the price be secured?
  • What procedures should be set forth for dispute resolution?

Value for a buy-sell agreement is often determined by fixing it annually at the stockholders’ meeting. In this case it is critical that the value be updated every year, as a stale value will result in a windfall to one side, and a hardship to the other. An alternative is to require that a current valuation be performed whenever the buy-sell agreement is activated. If fixing the value annually is the best choice for your ownership group, it is nevertheless advisable to require a current valuation if the stockholders failed to update the fixed value at the last annual meeting.

Some businesses are conducive to valuation by formula. A properly designed formula will keep the value calculation up to date. The formula should be tested periodically to make sure it is still appropriate for the business, and includes the value of any non operating assets. All financial expressions used in the formula should be clearly defined. Many buy-sell agreements contain a “Russian Roulette” clause, which provides that any offer to purchase shares from a fellow owner is also an offer to sell shares at the same price. This clause is especially appropriate among two or three equal co-owners.

Call Ronald J. Adams, CPA, CVA, ABV, CBA, CFF, FVS, CGMA, at Foxboro Consulting Group, Inc. at (774) 719-2236; or e-mail us at: adams.r@foxboro-consulting.com for an appointment to help you design your buy-sell agreement in conjunction with your attorney.

Internal Revenue Code Section 83(b) Election

Property transferred in connection with performance of services (Internal Revenue Code § 83)

(a) General rule. If, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of—

(1) the fair market value of such property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over

(2) the amount (if any) paid for such property,shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. The preceding sentence shall not apply if such person sells or otherwise disposes of such property in an arm’s length transaction before his rights in such property become transferable or not subject to a substantial risk of forfeiture.

(b) Election to include in gross income in year of transfer.

(1) In general. Any person who performs services in connection with which property is transferred to any person may elect to include in his gross income, for the taxable year in which such property is transferred, the excess of—

(A) the fair market value of such property at the time of transfer (determined without regard to any restriction other than a restriction which by its terms will never lapse), over

(B) the amount (if any) paid for such property.

If such election is made, subsection (a) shall not apply with respect to the transfer of such property, and if such property is subsequently forfeited, no deduction shall be allowed in respect of such forfeiture.

(2) Election. An election under paragraph (1) with respect to any transfer of property shall be made in such manner as the Secretary prescribes and shall be made not later than 30 days after the date of such transfer. Such election may not be revoked except with the consent of the Secretary.

(c) Special rules. For purposes of this section—

(1) Substantial risk of forfeiture. The rights of a person in property are subject to a substantial risk of forfeiture if such person’s rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual.

(2) Transferability of property. The rights of a person in property are transferable only if the rights in such property of any transferee are not subject to a substantial risk of forfeiture.

(3) Sales which may give rise to suit under Section 16(b) of the Securities Exchange Act of 1934. So long as the sale of property at a profit could subject a person to suit under section 16(b) of the Securities Exchange Act of 1934, such person’s rights in such property are—

(A) subject to a substantial risk of forfeiture, and

(B) not transferable.

(d) Certain restrictions which will never lapse.

(1) Valuation. In the case of property subject to a restriction which by its terms will never lapse, and which allows the transferee to sell such property only at a price determined under a formula, the price so determined shall be deemed to be the fair market value of the property unless established to the contrary by the Secretary, and the burden of proof shall be on the Secretary with respect to such value.

(2) Cancellation. If, in the case of property subject to a restriction which by its terms will never lapse, the restriction is canceled, then, unless the taxpayer establishes—

(A) that such cancellation was not compensatory, and

(B) that the person, if any, who would be allowed a deduction if the cancellation were treated as compensatory, will treat the transaction as not compensatory, as evidenced in such manner as the Secretary shall prescribe by regulations,

the excess of the fair market value of the property (computed without regard to the restrictions) at the time of cancellation over the sum of—

(C) the fair market value of such property (computed by taking the restriction into account) immediately before the cancellation, and

(D) the amount, if any, paid for the cancellation,

shall be treated as compensation for the taxable year in which such cancellation occurs.

(e) Applicability of section. This section shall not apply to—

(1) a transaction to which section 421 applies,

(2) a transfer to or from a trust described in section 401(a) or a transfer under an annuity plan which meets the requirements of section 404(a)(2),

(3) the transfer of an option without a readily ascertainable fair market value,

(4) the transfer of property pursuant to the exercise of an option with a readily ascertainable fair market value at the date of grant, or

(5) group-term life insurance to which section 79 applies.

(f) Holding period. In determining the period for which the taxpayer has held property to which subsection (a) applies, there shall be included only the period beginning at the first time his rights in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier.

(g) Certain exchanges. If property to which subsection (a) applies is exchanged for property subject to restrictions and conditions substantially similar to those to which the property given in such exchange was subject, and if section 354, 355, 356, or 1036 (or so much of section 1031 as relates to section 1036) applied to such exchange, or if such exchange was pursuant to the exercise of a conversion privilege—

(1) such exchange shall be disregarded for purposes of subsection (a), and

(2) the property received shall be treated as property to which subsection (a) applies.

(h) Deduction by employer. In the case of a transfer of property to which this section applies or a cancellation of a restriction described in subsection (d), there shall be allowed as a deduction under section 162, to the person for whom were performed the services in connection with which such property was transferred, an amount equal to the amount included under subsection (a), (b), or (d)(2) in the gross income of the person who performed such services. Such deduction shall be allowed for the taxable year of such person in which or with which ends the taxable year in which such amount is included in the gross income of the person who performed such services.

 

 

By Ronald J. Adams, CPA, CVA, ABV, CBA, CFF, FVS, CGMA – Call Mr. Adams at: (774) 719-2236; or E-mail  Mr.  Adams at:  adams.r@foxboro-consulting.com

Business Valuation: Baby Boomer Business Owners Retiring and the Need for Adequate Planning

Trends in the Baby Boomer Population

Baby boomers now comprise approximately 78-80 million Americans and account for the largest age cohort of the population in the United States. This age cohort includes those born between 1946-1964. Of this population age cohort, approximately 10.0%, or 8.0 million Americans have household incomes greater than $50,000, and also own small businesses.

Simply put, 7.0-8.0 million businesses in the United States are owned by individuals that will retire from their businesses. Currently, 33% of business owners in America will successfully transfer their family business to the next generation (Family Firm Institute), and a mere 13% are passed on to the third generation.

If you fall into the majority of US business owners (67%), then your children have most likely opted to not follow in your footsteps of taking over the family business, leaving you with significant, life shaping decisions. It is probably safe to say that 5 million (67%) baby boom business owners do not have children willing to take over their family’s privately held business.

If you fall into this latter 67% category, then what is your exit strategy with your business?

Ownership Transfer Options

Business owners will find themselves evaluating various ownership transfer options for their companies, especially as they near those golden years.  Wise owners have planned for the transition of their businesses from the first day they stated their businesses.

Appropriate planning, well in advance of any contemplated transaction, will enable business owners to maximize overall company performance, as well as the rate of return on their investment. However, in reality, most business owners exit their businesses with less than six months of advanced planning. Smart business owners are beginning to initiate the following courses of action with regards to their businesses:

  • Keep the business well into their retirement years, possibly leaving it to estate planning, and estate settlement proceedings,
  • Gift ownership interests in the business to children and other heirs,
  • Dissolve the business should competent leadership not be in place after Retirement, and
  • Sell the business to a qualified buyer and have financial stability for retirement and provide a legacy to one’s heirs.

The Business Exit Advisory Team

A typical exit advisory group could consist of an attorney, business appraiser, investment  banker, accountant, and financial planner. The owner business exit planning process can take 6-18 months, and is usually a painstaking process. Professionals and advisors to guide the business exit planning process will assist in getting your exit process right.

Business Valuation –  A Tool to Assist You  in Your Business Exit Planning

In order to start the process of selling your business, initiating estate planning, or gifting of ownership interests in your business, you first need to determine what the business is worth from a fair market value perspective.

Why the fair market value?  Simply put, the Internal Revenue Service (IRS) will utilize this standard of value when assessing related gift and estate taxes, or normal and capital gains taxes on the sale of the business to independent third parties. Internal Revenue Service (IRS) Regulations define 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”.

Determining the fair market value of your business can be a complex process depending on the particular facts and circumstances surrounding your business. Issues and decisions that you may confront include the determination of how much of the ownership interest will be transferred or sold. For example, will you transfer or sell just a minority ownership interest (<50.0% of the ownership interest), or a controlling interest in the business (generally greater than 50.0% ownership interest), or in the case of an outright sale (100% ownership interest).

Valuation Specialist

Professional valuation specialists with appropriate certification and accreditation from one of  the  four credentialing bodies, will be able to assist you by determining the fair market value of your business enterprise, as well as the specific value of any ownership unit, common stock, partnership interest, or membership unit.  The valuation credentialing bodies include: the National Association of Certified Valuation Analysts (NACVA), the American Society of Appraisers (ASA), the Institute of Business Appraisers (IBA), and the American Institute of Certified Public Accountants (AICPA).

Based on discussions and recommendations from either your accountant, or corporate or estate planning attorney, you can find a professional, independent valuation specialist who can conduct an accurate business valuation assessment. For the purpose of planning and determining fair market value, the cost to prepare a valuation will vary based on the size of the business, its complexity, the complexity of the company’s capital structure, whether there is real estate involved, and other specific facts and circumstances.

Valuation Process

Once you have retained a valuation specialist and provided your Company’s financial and operational data and information, the specialist will begin working and analyzing your Company’s historical financial performance by reviewing five years of tax returns and historical audited financial statements, comparing your Company’s sales and earnings financial information to recent purchase transactions in the merger & acquisition (M&A) market (direct market data method), making discount adjustments for lack of control. The valuation specialist will also compare your Company to companies traded on the national stock exchanges (guideline public companies method) which participate in your company’s industry segment, making adjustments for discounts for lack of marketability.

In addition the valuation specialist will review and analyze your budget and any 3-5 year forecast that you may have prepared. The value of your company is worth the present value of future economic benefits (capitalization of earnings and discounted cash flow methods).  The valuation specialist will want to interview management as part of the valuation exercise. The valuation specialist may select the results of one of these valuation methods, or apply weights to all three methods to derive the Company’s fair market value.

Once you have determined the fair market value of your Company’s business enterprise, you can then make decisions with confidence and choose your exit option, accordingly. Once you complete the business valuation process, you will also be able to better understand the value drivers specific to your type of business and industry.  If you Company’s value is more than you expected, you may be motivated to sell your Company sooner rather than later.

If the value is lower than you had expected, you may want to defer selling immediately and regroup and reorganize your business so as to increase value in consideration of a future sales date.  Timing is everything in the sale of a business.

 

 

Last Thoughts

The are several questions that the business owner must ask: a.) what new challenges, traveling plans, or personal hobbies do you want to take on during the golden years of your life?  b.) can you afford to do these things and live comfortably?

Determine your ideal end result, then reverse engineer your plan to reach those desired goals. For the retirement planning of a business owner, the starting point in all of this should be a business valuation. It takes years to build a successful business, therefore, know the value of your business when the time is right.

If you have any questions you may contact:

Ronald J. Adams, CPA, CVA, ABV, CBA, CFF, FVS, CGMA

Managing Director – Valuations

Foxboro Consulting Group, Inc.

36 Lancashire Drive

Mansfield, MA 02048

(774) 719-2236 – office

(508) 878-8390 – mobile

E-mail: adams.r@foxboro-consulting.com

Stock Valuation and Stock Option Pricing Alternatives

Publicly traded companies, venture capital firms, and private equity firms are now dealing with the same set of financial accounting & reporting, tax reporting and disclosure requirements related to their stock options. These requirements include ASC 718 (formerly SFAS 123R) – Accounting for Stock based Compensation,  Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 107, and Internal Revenue Code (IRC) Section 409A regulations, which all provide guidance on valuation for purposes of valuing stock options and setting the stock option exercise price.

ASC 718 deals with the voluntary expensing of the cost of employee stock options (ESOs), and ASC 718 requires a public entity to measure and recognize the cost of the employee stock option based on the options grant-date fair value, where the grant date fair value will be estimated using option-pricing models adjusted for the unique characteristics and features of those financial instruments. ASC 718 also contains related guidance on certain tax issues associated with ESOs and disclosures that must be provided in the notes to the financial statements. SEC-SAB No. 107 contains implementation guidance emphasizing that the “grant date fair value” should be the equivalent of an exchange price for ESOs. All of these regulations have three main parts: 1) the fair value measurement of the financial instrument, 2) recognition on the balance sheet and 3) recognition of the compensation cost of ESOs in the income statement.

Major Risk Areas

The 2004 passage of the American Jobs Creation Act brought with it the addition of IRC Section 409A.  Section 409A carries potentially burdensome tax implications for the company and key executives or other individuals compensated under non-qualified deferred compensation plans.

Board of director compensation committees must now exert due diligence and extreme care to structure company plans in such a way as to comply with the requirements of IRC Section 409A. The major areas for risk and uncertainty reside in following stock option valuation areas:

a)     The way stock options are valued, the methods used and the reasonability of the methods

b)     Whether or not the valuation methods utilize established economic and financial theories used in the valuation field

c)     The option strike price as compared to the fair market value of the underlying common stock at the grant date,

d)     The likelihood of forfeiture of those stock options before the vesting period.

Boards of directors and their related compensation committees are concerned about potential liability for the company, tax implications for key employees and the adverse consequences resulting from:

a)     Unpaid withholding taxes due upon option vesting,

b)     Employees incurring ordinary income tax,  20% additional tax penalties, and interest charges under Section 409A if discounted options are granted inadvertently,

c)     Any potential litigation that may result from the above mentioned circumstances.

Many boards may wish to rely on outside experts for their valuations to minimize such exposure thereby strengthening their position with the IRS in the event of an audit.  Foxboro Consulting Group, Inc. has outlined its valuation approach and solution below in order to assist your company to mitigate the risks outline above.

Other companies may respond to IRC Section 409A regulations in any of the following three ways:

 1)  Status Quo – A company may choose to retain its existing option pricing practice. If the company’s option exercise prices equal or exceed the fair market value of the underlying stock, Section 409A generally will not apply to such options (see the flow chart detailed below). This is true whether or not the company applies any of the rules or factors set forth in the proposed regulations. If the company’s option exercise prices are later found to be below fair market value upon audit by the IRS, then the burden will be on the company to prove that its stock valuation method was reasonable by referencing the standards and rules found in the tax code regulations. If the company’s current valuation method doesn’t consider or reference the factors and methods outlined in the tax regulations, or if it uses no valuation method at all, the company will fail to satisfy this burden, and the adverse consequences of Section 409A will apply.

2)  Informal Valuations Using Specified Factors – A company may choose to perform its own internal stock valuation based on specified factors set forth in the regulations, which are called “general valuation factors.” If the company’s option exercise prices are later found to be below fair market value, then the burden will be on the company to prove that its stock valuation method was reasonable. The company will improve its chances of satisfying this burden if it employs the factors specified in the regulations.

3)  Adopt One of the New “Presumptive” Methods – A company may choose to adopt one of the “presumptive” stock valuation methods set forth in the regulations, thereby putting the burden on the IRS to prove that both the company’s stock option prices are below fair market value and  the company’s application of the presumptive method was “grossly unreasonable.”

These presumptive methods are described below. They involve either a written valuation by an appraiser or other person with knowledge and experience in stock valuation, or a binding formula.

Presumptive Valuation Methods

The regulations specify three methods that will be presumed reasonable if consistently used for all of an employer’s equity-based compensation arrangements. The valuation resulting from any of these presumptive methods will be considered to be fair market value and may only be rebutted by the Internal Revenue Service if the company’s application of the method is found to be “grossly unreasonable.” The three presumptive methods are as follows:

1) Independent Appraisal Presumption. A valuation performed by a qualified independent appraiser using traditional appraisal methodologies (as would be applicable to an appraisal of common stock for estate tax planning or an employee stock ownership plan ESOP) will be presumed reasonable if it values the stock as of a date that is no more than twelve months before the applicable stock option grant date. However, this presumption would not apply if events subsequent to the appraisal date have a material effect on the company’s stock value.

2) Illiquid Start-Up Presumption. A special presumption is provided for “illiquid stock of a start-up corporation.”   A start-up corporation is defined as a corporation with no publicly traded stock that has conducted business for less than 10 years.

A valuation of illiquid start-up stock will be considered reasonable if five requirements are satisfied:

  1. The valuation is evidenced by a written report;
  2. The valuation takes into account the General Valuation Factors described below. As indicated below,   events subsequent to the valuation must be taken into account and may render an earlier valuation inapplicable;
  3. The valuation is performed by a person with significant knowledge and experience or training in performing similar valuations;
  4. The stock being valued is not subject to any put or call right, other than the company’s right of first refusal or right to repurchase stock of an employee (or other service provider) upon termination of service;
  5. The company does not reasonably anticipate an IPO, sale or change in control of the company within twelve months following the equity grant to which the valuation applies.

The valuation factors specified in the regulations incorporate the following:

  • The tangible and intangible assets of the company
  • The present value of future cash flows
  • The public trading price or private sale price of comparable companies
  • Control premiums and discounts for lack of marketability
  • Whether the method is used for other purposes
  • Whether all available information is taken into account in determining value.

Even if a valuation applies these factors, it will not be considered reasonable if it is more than twelve months old.    In addition, significant events occurring even before the twelve month anniversary will require the valuation to be updated. Such events would include:

  • The possibility of/or plans for a future investment in the company by an outside investor,
  • An initial public offering or sale of the company,
  • Resolution of material litigation
  • The issuance of a patent.

3) Binding Formula Presumption. A valuation based on a formula used in a shareholder buy-sell agreement or similar binding agreement will be presumed reasonable if the formula price is used for all non-compensatory purposes requiring the valuation of the company’s stock, such as regulatory filings, loan covenants, and sales of stock to third parties. This method will not be available if the stock may be transferred other than through operation of the buy-sell or similar arrangement to which the formula price applies. Because of the restrictive conditions on use of this presumption, we do not expect it to be widely utilized by private technology and life sciences companies.

Foxboro Consulting Group, Inc.  Stock Option Valuation Solution

Foxboro Consulting Group will provide a valuation analysis and report that will stand up under rigorous IRS scrutiny. Our stock and stock option valuation analysis will consider all three basic approaches to value: income, market/sales comparison and cost.

Where more than one approach is utilized to form an opinion of value, the results of each approach will be reconciled giving consideration to the type of asset, the applicability of the approach, and the nature and reliability of the data used.  Our valuation will take into consideration many factors that influence the fair market value of closely held common stock and employee stock options including, but not limited to, the following:

  • The nature and dynamics of the Company’s business, including its lines of business, its competitiveness, its customer base and management strength;
  • The economic and operating outlook of the Company business and its historical and prospective operating results;
  • The book value of the stock and the financial condition of the Company as of the valuation date and its capability to finance and sustain future operations;
  • Valuation of the Company’s business by estimating the present value of its projected operating net cash flow, as well as analyzing the earning and dividend paying capacity;
  • Analyzing the enterprises intangible assets and goodwill;
  • Correlation of the public market price (and corresponding investor ratios) of common stocks of corporations engaged in lines of business similar to the Company that have their stocks traded in a free and open market, either on an exchange or over-the-counter;
  • Examining the recent sale of stock and the size of the block of stock to be valued;
  • The transfer features and characteristics of the common stock and employee stock options including their marketability and vesting restrictions.

Our valuation study will be executed in accordance with practices currently accepted and utilized by the financial and valuation communities and in conformity with the Uniform Standards of Professional Appraisal Practice (USPAP) promulgated by the Appraisal Standards Board of the Appraisal Foundation, as well as meet the requirements of IRS Revenue Ruling 59-60 of the Tax Code.

Stock Option Pricing Flow Chart

Stock_option_pricing_flow_chart

Practical Implications for Private Companies

The proposed regulations will affect private company valuation and option grant practices differently at three (3) different stages in the private company lifecycle.

Founding Stage – During the very early stage of a typical technology company, in particular from the time of founding to the time when the company begins to have assets (whether tangible or intangible) and operations and begins to make option grants to multiple employees, we generally do not expect to see formal appraisals or written stock valuations. Companies at this stage typically issue stock (rather than stock options) to their initial founding shareholders, and Section 409A generally does not apply to employee stock issuances. Thus, the concern noted above about issuing discounted stock options is often not present at this stage. It is still necessary to value the new company’s stock to determine whether the company must report taxable income to the founders on their stock purchases (this would generally be the case if the amount paid by the founders for their stock is less than its fair market value). However, at this stage, performing a meaningful valuation using the General Valuation Factors is often impossible due to the company’s lack of assets and financial history or projections.

Post-Founding to Expectation of IPO or Sale – Many private technology companies will now obtain periodic, independent appraisals of stock value for purposes of setting the exercise price on their stock options, once they have assets (whether tangible or intangible) and operations and begin to make option grants to multiple employees. There is no clear line demarcating when a company has entered this stage, and in some cases, the company’s first venture capital or “angel” financing will mark the company’s entry into this stage. This would be particularly true in cases where the first financing occurs soon after the founding. In other cases, the company will enter this stage long before its first financing, perhaps because the company develops assets and operations without financing and these assets and operations can be valued using the General Valuation Factors. The company’s board of directors will need to rely on its judgment and consultations with counsel to determine when it makes sense to begin obtaining independent stock valuations.

As noted above, the proposed regulations do not require that a company obtain a formal appraisal. Why, then, do we expect to see technology companies obtaining independent appraisals of their stock value for purposes of pricing stock options?

Here are some of the reasons:

  • The Independent Appraisal Presumption is the clearest presumption available under the proposed regulations. Relying upon this presumption provides the best protection against the adverse consequences of Section 409A.
  • Many boards of directors will be concerned about possible liability for both the company (unpaid withholding taxes due upon option vesting) and option holders (the 20% additional tax and interest charge) under Section 409A if discounted options are granted inadvertently. Thus, we expect many boards will wish to rely on outside experts for their valuations to minimize such exposure.
  • For financial accounting purposes, auditors have long pressed private companies to be more rigorous about their stock valuations. This pressure from the auditors will increase as the new option expensing rules under FAS 123R go into effect for calendar years beginning after December 31, 2005. In addition, we have seen accounting firms refuse to accept new audit engagements with private companies unless the company agrees to obtain regular independent appraisals of its stock.

Most technology companies experience frequent value-changing events (such as financing transactions, development milestones, granting of patents, and customer wins). Accordingly, companies will choose to rely on independent appraisals and will choose to obtain annual appraisals with quarterly or semi-annual updates to their valuation—presumably from the same appraiser that performs the annual valuation — in order to ensure that they have a valuation that takes all available information into account when setting the exercise price for stock options granted during a given year. Grant dates for such companies likely will cluster around appraisal dates (or the dates of appraisal updates) to ensure that options are priced appropriately.

Of course, many companies at the post-founding/pre-expectation of IPO or sale stage may choose to rely instead on the Illiquid Start-Up Presumption, or simply may forego any of the presumptive methods. Although the proposed regulations are unclear on this point, it is possible that the Illiquid Start-Up Presumption may be satisfied by a written report produced by one of the company’s internal financial personnel or a board member who has experience or training in stock valuation. This would obviously be less expensive and perhaps more timely than a formal outside appraisal. However, if more and more companies begin to rely on the Independent Appraisal Presumption, and if auditors continue to pressure companies to obtain outside valuations, we expect that fewer boards of directors will choose to rely on alternative methods. Appraisal firms, over time, will develop more cost-effective and timely appraisal procedures for private company stock to meet the demands triggered by these new regulatory pressures.

After Expectation of IPO or Sale. Once a company reasonably anticipates that it will undergo a change in control event or an IPO within the next 12 months, the company no longer may rely on the Illiquid Start-Up Presumption. We expect most companies at this stage (whether on track for an IPO or sale) effectively will be required to use the Independent Appraisal Presumption.

  • For those companies planning an IPO, their auditors and SEC rules will likely require formal appraisals of their stock for financial accounting purposes.
  • Most importantly, for those companies planning a sale, the buyer now will be concerned about the company’s compliance with Section 409A and will want some assurances that the company has not granted discounted options. Complying with the Independent Appraisal Presumption will be the clearest way to provide such assurances.

What to Do About Previous Option Grants

Many private companies have outstanding options that either were granted intentionally with a discounted exercise price, or were priced without reference to the valuation factors and methodologies described in the proposed regulations. Some of these stock options are subject to Section 409A because they were granted or vested after certain “grandfather” dates (see the attached chart below for those dates).

What should companies do about such option grants?

The response may depend on factors such as:

(i) the size of the prior grant;

(ii) the extent to which—in the board’s (or management’s) judgment—the exercise price of the prior grant may be less than the grant date fair market value;

(iii) which (if any) valuation method was used to price the prior option grants;

(iv) the number of prior grants and option holders that may be affected; and

(v) the potential tax exposure for the company and option holders if the options were determined to be under priced. If the option in question is an “incentive stock option” intended to qualify under Section 422 of the Internal Revenue Code (commonly referred to as an “ISO”), the board also may wish to discuss with legal counsel whether the option is protected against the application of Section 409A because the board’s prior determination as to fair market value was made in good faith. The board may choose to obtain an after-the-fact valuation (whether formal or informal) to support the prior grant price or at least ascertain whether there is a discount on prior options.

Fix Prior Discounted Stock Options

If the board determines that action is needed to avoid the application of Section 409A to prior option grants, there are several available alternatives. The proposed regulations and IRS Notice 2005-1 allow companies time to “fix” discounted stock options and other deferred compensation arrangements that do not comply with Section 409A. The chart outlined below describes various option grant permutations, whether Section 409A is applicable, whether a correction is appropriate, and the applicable deadline.

For existing discounted stock options, one of the following correction methods may be used in order to avoid the adverse consequences of Section 409A:

  • Before January 1, 2007, raise the strike price of the non-complying option to fair market value as of the option grant date. In addition, it is permissible for the company to pay the option holder a cash or stock bonus (which will be taxable) to compensate for any lost economic benefit. If the company “ties” the cash or stock bonus to the increase in the option price (i.e., as a means of obtaining option holder consent), the cash or stock bonus must be paid before January 1, 2006 (notwithstanding that the increase in the exercise price need not occur until January 1, 2007). Alternatively, the cash or stock bonus may be made subject to a vesting schedule and/or delivered in the future as part of a deferral arrangement. If the cash or stock is to be paid or delivered in the future, such arrangement would need to comply with the requirements of Section 409A, unless payment or delivery is made within a short period of time after vesting pursuant to the short-term deferral exception (2½ months after the taxable year of vesting).
  • Exercise the option before January 1, 2006.
  • Before January 1, 2006, exchange the discounted option for stock having a value equal to the difference between the fair market value and the exercise price (i.e., the “spread” on the option).
  • Before January 1, 2006, exchange the discounted option for cash equal to the spread on the option. Alternatively, the cash may be made subject to a vesting schedule and paid at a future date; such an arrangement would need to comply with the requirements of Section 409A, unless payment is made within a short period of time after vesting pursuant to the short-term deferral exception.

 

Note that any corrective action, other than merely raising the exercise price of the option, may result in immediate or deferred application of income and employment taxes, but if properly structured would avoid the application of the additional taxes imposed by Section 409A. Corrective action usually will require board approval and option holder consent as well. In certain cases, corrective action may have financial accounting consequences.

 

Decision Matrix for Previously-Granted Discounted Options

Description of Option

Status under 409A

Action Corrective Needed?

At-the-money (non-discounted) stock option granted at any time Exempt from 409A by virtue of the general rule exempting at-the-money option grants None needed — make sure no material modifications are made that will result in loss of exemption
Discounted stock option granted prior to 10/4/04 and earned and vested by 12/31/04 Exempt from 409A by virtue of the grandfather provisions. None needed — make sure no material modifications are made that will result in loss of grandfather status
Discounted stock option granted after 10/3/04 and before 12/31/04 and earned and vested by 12/31/04. (Option not yet exercised.) Potentially subject to 409A unless it can be shown to be part of a pattern and practice Determine if a pattern and practice of granting discounted options in the relevant time period can be established. If yes, see above. If no, see below.
Discounted stock option granted prior to 12/31/04 but not earned and vested by 12/31/04. (Option not yet exercised.) Subject to 409A since it qualifies for neither the general exemption nor the grandfather exemption, but eligible for transition relief See list of correction alternatives in text of Alert and discuss with counsel.
Discounted stock option granted after 12/31/04 and prior to 12/31/05 Subject to 409A, but eligible for transition relief See list of correction alternatives in text of Alert and discuss with counsel.
Option (whether or not discounted) that is with respect to stock other than common stock and was not earned and vested on 12/31/04. An option of this type may be part of a “carve out plan” for a privately held company. Does not qualify for the at-the-money exemption, but arguably can rely on Notice 2005-1 until 1/1/07. Can still qualify for the ISO exclusion. Corrective action may be required. Discuss with counsel.
Option having a “feature for the deferral of compensation” (other than vesting) Apparently subject to 409A Corrective action required. Discuss with counsel.

 

Notes

  1. Although the proposed regulations are not yet technically effective, IRS Notice 2005-1 (guidance under Section 409A that is currently effective) requires taxpayers to comply with Section 409A in “good faith” during this transition period. Compliance with the proposed regulations will be considered good faith for this purpose. Because the proposed regulations contain the only rules on numerous issues under Section 409A, the IRS is likely to apply the principles described in the proposed regulations even before they become effective, and many companies likely will wish to utilize those principles to ensure good faith compliance during this transition period.
  2. Although the IRS has informally indicated that the 20% additional tax is not a withholding tax, no formal guidance to this effect has been issued.
  3. In some cases, newly founded companies obtain venture capital or “angel” financing simultaneously with (or soon after) the founders’ stock issuances. In such cases, it has been and will continue to be necessary to take into account the effect of the financing on the company’s prospects and assets for purposes of determining the tax implications of the founders’ stock issuances. It is, of course, also permissible to take into account differences in the stock purchased by the investors (typically preferred stock with liquidation preferences and special voting rights) and the stock issued to the founders (typically common stock).

Conclusion

The Section 409A regulations, along with recent changes in the ASC 718, and SEC-SAB No. 107 financial accounting rules and practices will motivate the need for stock option pricing and compensatory stock valuation among venture capital firms, private equity and public companies. Boards of directors should be consulting with valuation specialists to determine how best to address these changes. You can contact us by calling Ronald J. Adams, CPA, CVA, ABV, CBA, CFF, FVS, CGMA, Managing Director – Valuations, at Foxboro Consulting Group, Inc. (774) 719-2236; for a free consultation. Mr. Adams is a certified valuation analyst (CVA), he is accredited in business valuation (ABV), he is a certified business appraiser (CBA), he is certified in financial forensics (CFF), he is certified in forensic & valuation services (FVS), he is a chartered global management accountant (CGMA), and he is a certified public accountant (CPA).

 

 

Sources:

Real Options Analysis – Tools and Techniques for Valuing Strategic Investments and Decisions – Wiley/Finance, 2006,  Johnathan Mun, Ph.D.

Valuing Employee Stock Options – Wiley/Finance, 2004,  Johnathan Mun, Ph.D.

IRS – Revenue Ruling 59-60

Financial Reporting Alerts – Employee Stock Option Accounting: FASB 123(R), SEC SAB No. 107 – AICPA – Louis P. LeGuyader, Ph.D., CPA

Financial Accounting Standards Board – Statement of Financial Accounting Standards No. 123 – Accounting for Stock-Based Compensation, October 1995

Cooley Godward, LLP –  Article, October 19, 2005

Guidance Under Section 409A of the Internal Revenue Code – Notice 2005.1 – Stephen Tackney of the Office of Division Counsel/Associate Chief Counsel; Neil D. Shepherd of the Office of Division Counsel/Associate Chief Counsel.

Securities and Exchange Commission – 17 CFR Part 211 Staff Accounting Bulletin No. 107 – March 29, 2005.

 

By Ronald J. Adams, CPA, CVA, ABV, CBA, CFF, FVS, CGMA