If you are a CEO or a CFO of a high growth startup, it is vital to understand how to value your company correctly. Here is a quick list of questions this lunch will help you answer: Do you offer or are you planning to offer your employees stock options? Do you know the difference between ISOs and non-ISOs? Do you understand the general valuation concepts and approaches that the IRS has outlined, especially as they apply to early-stage companies? Did you know that if you run afoul of the 409A rules, your employees could have an unpleasant tax surprise and that some of that responsibility could revert back to you as the employer? Do you know if and when you need to engage an outside expert to assist with a valuation? This is a limited seat lunch to teach issues of valuation for equity compensation and ask specific questions about your company. Experts: – Alicia Amaral, Scalar Analytics – Scott Goodwin, Wolf & Company

1. MEMBER OF PKF NORTH AMERICA, AN ASSOCIATION OF LEGALLY INDEPENDENT FIRMS © 2010 Wolf & Company, P.C.
Know Your Valuation For Equity
Compensation (and Avoid the
Perils of 409A)
Exclusively for

2. 2
Introductions
• Scott Goodwin – Wolf & Company, PC
– Member of the Firm
– Technology Services Team Leader
– TCN board of directors and program committee chair
• Alicia Amaral – Scalar Analytics
– Managing Director
– Tufts University, Entrepreneurial Finance
– CPA and Certified Valuation Analyst, CVA
– Past CFO

3. 3
Who is Wolf & Company?
• Boston based, regionally focused
• 19 owners and 200 professionals in three offices
• Niche focused
– Technology Services Team
• Provide our clients with direct access to owner-level
expertise
• Ability to grow with you

4. 4
Who is Scalar Analytics?
• 900+ valuations per year
• Majority of clients backed by venture capital firms
and angel groups
• Clients in virtually every industry
• Work with all of the “Big 4” audit firms and
countless regional firms

5. 5
Agenda
• Overview of stock compensation plans
• Overview of IRC Section 409A
• The who, what, why and how of valuations
• Q&A

6. 6
Stock Compensation
Overview
• Common forms of stock compensation
– Founders shares
• Not really compensatory
• Beware of retroactive vesting provisions
• How long can you issue them?
• Other issues
– Founders coming and going

7. 7
Stock Compensation
Overview
• Common forms of stock compensation
– Option
• Incentive Stock Options (“ISOs”) – tax treatment
– No tax at issuance
– No tax upon vesting
– No tax upon exercise
– Only taxable upon sale of underlying stock
– Ability to get LT cap gain tax
• ISO criteria
– 8 criteria for being considered an ISO
– Three of the more important ones
» Issued under a formal written plan
» Exercise price >= FMV of stock
» Can’t be issued to non-employee

8. 8
Stock Compensation
Overview
• Common forms of stock compensation
– Options
• Non-quals (“NQs”) - tax treatment
– No tax at issuance
– Taxable income equal to the difference between FMV of the stock and the
exercise price
– Ordinary income
» Possible additional tax when stock sold
• Factors to consider when issuing options
– Tax advantages
– Less immediate dilution
– Keep stock in few hands for longer
– Difficult to value and account for

9. 9
Stock Compensation
Overview
• Common forms of stock compensation
– Restricted stock
• Generally common stock with vesting or repurchase rights
• General tax treatment
– Taxed as the shares vest
– Taxable amount based on FV of shares on the date of vesting
– Ordinary income
• Factors to consider
– Can be tax advantages
» 83(b) elections
» Start LT cap gain clock ticking
– FV is easier to establish for a share of stock than an option
– Better understood by recipients
– True dilution
– End up with more shareholders
» Consideration when you want to pay vendors with shares. Do you want them as
shareholders?

10. 10
Overview of IRC
Section 409A
• What is it?
– Part of the IRC – issued by the IRS
• No impact on accounting rules
– Very comprehensive and far reaching impact/scope
– Regulation governing a wide array of non-qualified deferred
compensation arrangement, including options
• “Deferred compensation” – legally binding right to receive compensation in
one tax year that is or may be taxable in a subsequent tax year
– Reaction to perceived abuses from some earlier scandals
including the option back-dating scandal

11. 11
Overview of IRC
Section 409A
• How does it impact stock compensation?
– Can no longer safely issue options using a rule-of-thumb or simple
board approval
– In-the-money options are impractical
– 409A has forced companies to get outside valuations of their
stock in order to appropriately set exercise prices
– 409A has forced companies to be more disciplined in their
granting process

12. 12
Overview of IRC
Section 409A
• What is the worst that could happen?
– An option issuance intended as an EE benefit could cause tax
problems for the recipient
– Lose the tax benefits of ISOs
– EE’s perspective
• Ordinary income in the periods in which options VEST rather than when they
are exercised
• Regular tax rates (rather than cap gains)
• 20% penalty
• Possible interest and penalties for late payment or underpayment
– ER’s perspective
• Very unhappy employees!
• Withholding obligation
• ER portion of employment taxes
• Possible responsibility for EE’s portion of withholdings
• Possible legal liability if sued by EE

13. 13
Overview of IRC
Section 409A
• What do you as an entrepreneur need to know to
stay out of trouble?
– With respect to options
• ISOs
– These have always been required to be recorded at FV so 409A really didn’t
change anything
– But did provide some guidelines that should be followed related to valuation
• Non-quals
– Will need to deal specifically with 409A
– General 409A compliance requirements
• Exercise price >= FMV of underlying common stock at grant date
• FMV must be determined by the “reasonable application of a reasonable
valuation methodology”

14. 14
Overview of IRC
Section 409A
• What do you as an entrepreneur need to know to
stay out of trouble?
– General 409A compliance requirements
• “Reasonable valuation methodology” must include consideration of:
– Tangible and intangible assets
– PV of future cash flows
– MV of the stock of similar companies
– Recent transactions
– Appropriate premiums and discounts
» Together, referred to as the “General Rule”
• Must be within 12 months of when valuation is being used
– Or more frequently based on a “significant events” in the business
– Safe Harbor Valuation Methods
• Safe harbors are not a “silver bullet”
– Shifts the burden of proof from you to the IRS related to valuation
– May only be rebutted by the Internal Revenue Service if the company's application
of the method is found to be "grossly unreasonable."

15. 15
Overview of IRC
Section 409A
• What do you as an entrepreneur need to know to
stay out of trouble?
– Safe Harbor Valuation Methods
• Independent appraisal
– Using the standard valuation methodologies
• Illiquid start-up
– Uses valuation factors outlined in General Rule
– Written report
– Company less than 10 years old
– Valuation performed by someone with significant experience, education and
training in this area (>= 5 years)
» CFO
» CEO
» Investment banker
– Reasonable expectation that no change in control within 90 days or IPO within 180
day

16. 16
Overview of IRC
Section 409A
• What do you as an entrepreneur need to know to
stay out of trouble?
– Safe Harbor Valuation Methods
• Binding formula
– Use formula based on book value, multiple of earnings or combination
– Stock transfers must be restricted
– All transactions must use the same binding formula

17. 17
Overview of IRC
Section 409A
• What are best practices at various stages of
development?
– Founding stage
• Founders stock and restricted stock more frequently than options
• Using general valuation factors is impractical due to limited amount of
information, operating history, etc.

18. 18
Overview of IRC
Section 409A
• What are best practices at various stages of
development?
– Start-up
• Friends and family or some angel financing
• Option issuances start
– Companies are looking at the cost/benefit of getting a valuation
– Depends on your and the BODs risk tolerance
• If using Illiquid Start-up safe harbor
– Document qualification of person performing the calc
– Consult outside resources
– Get BOD approval and document
– For as long as you’re using the value, consider impact of events that may have
changed the value
• Be aware of possibility of changes in control in the near term

19. 19
Overview of IRC
Section 409A
• What are best practices at various stages of
development?
– Post-start up
• Venture financing, decent amount of revenue
• Almost all companies are opting for a formal outside valuation
• Updated annually
– Possibly mid-year depending on what developments take place during the year
• More likely to have changes in control at this stage
– Other things to keep in mind
• There has not been any case law in this area yet so how 409A will be applied
to options in practice is still unclear
• Modifications to options can trigger new 409A consideration
• In acquisition situation, don’t be surprised to be asked for documentation of
compliance with 409A

20. Standard of Value
• Fair Market Value
– Assumes hypothetical buyer
– This is standard for 409A (per IRS)
• Investment Value
– Assumes strategic buyer
409A ≠ VC investment
20

21. Investment Valuation
for Start-Ups
• Discounted Cash Flow???
• Berkus
• Bill Payne Method
• Risk Factor Simulation
• Venture Capital Method
21

22. David Berkus Method
22
$500k for each
• Good idea
• Prototype
• Quality Team
• Quality Board
• Initial Sale
Value $0 to $2.5 Million

23. Bill Payne Method
Factor
Management
Size of Opportunity/Market
Product/Service
Sales Channels
Stage of Business
Other
23
Weight
30%
25%
10%
10%
10%
15%
100%
Rating 100 = Average, 100+ = above average, 100- = below
Multiply result by $1.75M

24. Bill Payne Method Example
Factor
Management
Size of Opportunity
Product/Service
Sales Channels
Stage of Business
Other
24
Weight
30%
25%
10%
10%
10%
15%
100%
Rating
125
115
110
70
125
80
Total
37.50
28.75
11.00
7.00
12.50
12.00
108.75
Value = $1.75M * 108.75 = $1,903,125

25. Risk Factor Simulation Method
Risk Factor
Management
Stage
Funding Risk
Regulatory
Manufacturing
Sales & Mktg
Competition
Technology
Litigation
Reputational
Exit
25
Risk Factor
+$500k
+$250k
-$250k
0
+$250k
-$500k
+$250k
+$250k
$0
-$250k
+$250k
$250k
Valuation
Base $1.75M
Risk 250k
Value $2.0M

26. Venture Capital Method
Determine the
• Investor’s required rate of return (ROI),
and
• Terminal Value (TV)
Work backwards to get valuation (Post $)
TV can be either exit or next round
26

27. VC Method Example
• TV based on estimated revenues and/or Net
Income in terminal year
• Example:
– Estimated revenue in Year 5 is $40M
– Average multiplier for industry = 2
– So your estimated value of the company at the end of year
5 , or TV = $40M * 2 = $80M
*Note:
Can also estimate TV based on Net Income and apply average P/E multiples
27

28. VC Method Example
• ROI
• Say I sell an investment for $100M that I
purchased for $20M. What’s my ROI?
• Answer: $100M / 20M = 5x
• Same as TV/Post$ = ROI
• To solve for Post$: Post$ = TV/ROI
28

29. VC Method Example
• Say in our example that investor needs a 20X ROI
• Post $ = TV/ROI
• Post $ = $80M / 20
• Post $ = $4,000,000
29

30. Three Valuation Methods
Valuation Methods 409A
1. Asset/Cost Approach
2. Market Approach
3. Income Approach
30

31. 2. Market Approach
a) Recent securities transactions method
b) Comparable (guideline) public company method
c) Comparable transaction method
d) Industry-specific multiples
31

32. 2b. Market Example: Guideline
Public Company Method
Data for similar public companies in same industry
• Salesforce.com, Inc.
• Concur Technologies, Inc.
• Kenexa Corp.
• LogMeIn, Inc.
• Constant Contact, Inc.
32
In thousands of dollars (000) LTM Revenue LTM EBITDA NTM Revenue NTM EBITDA
Venture Co. $6,812.0 ($6,337.8) $14,380.7 ($3,166.6)
Mean Multiple 5.0x 22.1x 4.0x 19.2x
Implied Enterprise Value $33,809.2 N/ A $57,270.2 N/ A
Average Enterprise Value $45,539.7
Plus Cash $4,441.9
Market Value of Invested Capital $49,981.6

33. Steps in the Valuation Process
1. Take weighted average of applicable methods
(asset, market or income) to come up with
enterprise value
2. Allocate the enterprise value among classes of
stock
33

34. Valuation
7
Step 1 – Determine enterprise value using weighted
average of applicable methods (Asset, Market and Income)
Fair Market Value of Venture Co. as of September 30, 2012 Market Value of Method Weighted
In actual dollars Invested Capital Weighting Value
Adj. Book Value of Assets (Cost) $5,914,647 0.0% $0
Invested Capital (Cost) $22,182,037 0.0% $0
Recent Securities Transaction Backsolve (Market) $42,932,012 25.0% $10,733,003
Public Comps Valuation (Market) $49,981,604 25.0% $12,495,401
Acquisition Comps Valuation (Market) $55,094,153 25.0% $13,773,538
Discounted Cash Flow Valuation (Income) $44,606,522 25.0% $11,151,631
Weighted Market Value of Invested Capital $48,153,573
Less Debt ($1,750,000)
Weighted Equity Value $46,403,573

35. Step 2: Allocation
• Simply means “who gets what” in the event of an exit
• Common shareholders get paid after preferred
Remember that the purpose of 409A is to value
common stock
35

36. 36
Option Value Analysis Option 1 Option 2 Option 3 Option 4 Option 5 Option 6 Option 7 Option 8 Option 9 Option 10
Definition: Before this breakpoint… Series C
liquidation
preference
Series B & A
liquidation preference
Common
participates
Allocated options
exercise
Series A converts to
common
Common
Warrants
exercise
Unallocated
options
participate in
value
Series B converts
to common
Series C reaches
3.0x
participation cap
Series C converts
into Common
stock
Break Points $0 $20,771,210 $22,182,037 $25,812,886 $27,793,293 $28,582,104 $39,428,548 $56,429,660 $301,546,405 $421,162,792 Infinity
Current Equity Value (Price) $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573
Exercise $0 $20,771,210 $22,182,037 $25,812,886 $27,793,293 $28,582,104 $39,428,548 $56,429,660 $301,546,405 $421,162,792 Infinity
Riskfree Rate 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31%
Maturity (in years) 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0
Volatility 54% 54% 54% 54% 54% 54% 54% 54% 54% 54% 54%
d1 28.942 1.333 1.264 1.103 1.025 0.995 0.654 0.275 (1.501) (1.855) 0.000
d2 27.998 0.389 0.320 0.159 0.081 0.051 (0.290) (0.669) (2.445) (2.799) 0.000
Call Option Value: $46,403,573 $28,763,403 $27,871,048 $25,735,075 $24,660,647 $24,249,313 $19,421,999 $14,152,891 $929,712 $405,738 $0
Incremental Option Value $17,640,170 $892,355 $2,135,972 $1,074,429 $411,334 $4,827,313 $5,269,108 $13,223,179 $523,975 $405,738
Option Value of Security Option 1 Option 2 Option 3 Option 4 Option 5 Option 6 Option 7 Option 8 Option 9 Option 10
Series C $17,640,170 $0 $488,775 $204,543 $67,632 $795,364 $799,205 $1,933,391 $0 $60,031
Series B $0 $697,195 $0 $0 $0 $0 $0 $414,235 $19,010 $12,542
Series A $0 $195,160 $0 $0 $40,566 $229,734 $230,844 $566,020 $26,281 $17,340
Common $0 $0 $1,647,197 $689,319 $227,924 $2,680,416 $2,693,361 $6,604,011 $306,632 $202,309
Allocated $0 $0 $0 $180,567 $59,705 $702,136 $705,527 $1,729,925 $80,322 $52,995
A Warrants $0 $0 $0 $0 $15,507 $87,821 $88,245 $216,372 $10,046 $6,628
Common Warrants $0 $0 $0 $0 $0 $331,842 $307,524 $754,035 $35,011 $23,099
Unallocated $0 $0 $0 $0 $0 $0 $444,402 $1,005,190 $46,672 $30,793
Total $17,640,170 $892,355 $2,135,972 $1,074,429 $411,334 $4,827,313 $5,269,108 $13,223,179 $523,975 $405,738
Total Option Value Option Value Total Shares
Share Value
(Marketable)
Marketability
Discount
Share Value (Non-
Marketable)
Series C $21,989,112 5,934,632 $3.705 0.0% $3.705
Series B $1,142,982 1,239,906 $0.922 0.0% $0.922
Series A $1,305,945 1,714,171 $0.762 0.0% $0.762
Common $15,051,167 20,000,000 $0.753 35.7% $0.484
Allocated $3,511,178 5,239,012 $0.670 35.7% $0.431
A Warrants $424,620 655,276 $0.648 35.7% $0.417
Common Warrants $1,451,511 2,283,567 $0.636 35.7% $0.409
Unallocated $1,527,057 3,044,179 $0.502 35.7% $0.323
Total $46,403,573 40,110,742

37. Summary
• STEP 1
Enterprise Value $48,153,573
Less Debt (1,750,000)
Equity Value $46,403,573
• STEP 2
Allocation to common $15,051,167
Divided by # shares ÷ 20,000
Price per share = $0.753
37

38. Discount
• Discount for lack of marketability (DLOM)
 25 – 45%
• Discount for Venture Co. = 35.7%
• Price per share $0.753 less 35.7% =
$0.484 per share
38

39. Other Points
• Value is based on a number of assumptions that have a
material impact on the result
– Projected cash flows
– WACC
– DLOM
– Comparable companies
• Important to have a “DEFENDABLE VALUE” (IRS and
auditors)
• Important to review report for reasonableness of
assumptions. You know your business.
39

40. 40
QUESTIONS AND ANSWERS

41. 41
Thank You!
Scott Goodwin, CPA
sgoodwin@wolfandco.com
(617) 428-5407
Alicia Amaral
alicia.amaral@scalaranalytics.com
(617) 684-5510

42. 42
Resources
To be posted to TCN website:
• Detailed outline and PowerPoint presentation
• Scalar Analytics – white paper, “Section 409A – Common
Stock Valuation”