Equity Financing Issues for Start-Ups and Emerging Companies
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1 Equity Financing Issues for Start-Ups and Emerging Companies Presented by: Mike Smith, CFA, ASA, CVA Baden Gage & Schroeder, LLC Raphael Meyara CEO, AlgoValue, Inc. Gary Massey, CPA COO, AlgoValue, Inc.
2 Agenda Understand risk vs. uncertainty Identify common equity financing instruments Accounting codification Benefits and costs of equity compensation Analyze the start up and emerging company ecosystem Equity financing events and their impact Stock options and 409A Case study Questions and answers Copyright All Rights Reserved. 2
3 Risk vs. Uncertainty Risk» Unknown outcome with reasonably foreseeable distribution» Roll of dice or systematic business risk Uncertainty» Unknown outcome with unknown or very large (functionally unknown) probability distribution» Introduces ruin losses or failures Start-up and emerging companies» Entire investment return may be based on uncertain future events» Conventional valuation models break down Requires financial modeling to value Option pricing models Scenario analysis (probability weighted expected returns) Investors want to be compensated for uncertainty» Many accept or require equity financing arrangements Copyright All Rights Reserved. 3
4 Equity Financing Instruments Typical equity instruments» Common, restricted or preferred stock Cumulative dividends Convertibles» Stock options or stock appreciation rights (SARs)» Equity warrants (buy stock at a fixed price) Accounting standards codification for financial reporting» ASC 718 Guidance on employee share based equity compensation Share based payment awards to employees can be classified as equity or as a liability (obligation to repurchase)» ASC Equity compensation issued to non-employees Recognize when enforceable right to receive good/service or when issued Measurement is grant date fair value Copyright All Rights Reserved. 4
5 Benefits and Costs of Equity Compensation Employee benefits» Align employees with corporate goals (performance based awards)» Can be a large monetary incentive to employees» Service based awards rewards tenure Company benefits» Tax deductible» Employee incentive to align with corporate goals» Competitive compensation package (industry advantage) Costs» Plan origination fees» Monitoring & administration Valuation expenses Increased cost of financial statements Other risks of carrying the plan Copyright All Rights Reserved. 5
6 Start-Up and Emerging Company Eco-System Management Professional Services Equity Financing Events Board of Directors Employees Investors Making Complex Decisions Easy Copyright All Rights Reserved. 6
7 Equity Financing Challenges for Emerging Companies and Start-Ups Cost: workforce and human error Complexity: Current tools are unsatisfactory when requiring highly complex calculations Knowledge: High level of financial mathematics Time Consuming: Can take days or weeks to get results Copyright All Rights Reserved. 7
8 Equity Financing Events IRC 409A Grant of Stock Options Next Round Financing M&A or IPO How do they impact founders, shareholders and investors? Copyright All Rights Reserved. 8
9 IRC Section 409A» Treasury regulation 409A enacted in 2004, which regulates treatment of non-qualified deferred compensation paid by service recipient (employer) to a service provider (employee or contractor) Final Regs became effective January 1, 2009» Types of non-qualified deferred compensation Any plan, program or arrangement that defers the receipt of income: Certain employment agreements Bonus and incentive plans Severance or separation agreements Equity plans, (options, SARs) Split dollar life insurance Certain partnership payout arrangements Example (company agrees to pay for $xxxx of tax advice over a period) Seek expert legal advice if in doubt Copyright All Rights Reserved. 9
10 Exemptions from 409A The following arrangements are typically not subject to 409A:» Tax qualified plans (such as 401(k), 403(b) plans, ISOs and ESOPs).» Bona fide vacation, sick leave, compensatory time, disability or death benefit plans, COBRA heath benefits. Stock options and SARs are not deferred compensation subject to section 409A if: Exercise price is never less than the fair market value (FMV) of the underlying stock on the grant date Stock right is granted on service recipient stock Stock right does not include any deferral feature other than the deferral of income from the grant date until the option exercise date» Restricted stock Dividends on restricted stock may be subject to 409A.» Other exceptions Certain payments made solely upon involuntary termination. Copyright All Rights Reserved. 10
11 409A Safe Harbors Three Safe Harbor Methods for good faith estimate» Valuation determined by a qualified independent appraiser» Reasonable good faith estimate for start-ups: < 10 yrs as business Performed by a qualified internal appraiser with significant knowledge, experience (5 yrs), education or training in performing similar valuations Using reasonable method - Regulations specify criteria to consider NOT available if stock is subject to right of repurchase that doesn t lapse» Formula based valuation Consistently applied to ALL transactions and to all classes of stock Stock must be subject to permanent restriction on transfer Restrictive Copyright All Rights Reserved. 11
12 When Do You Need a Valuation? Needed to set fair market value of awards granted» Outside appraiser If company in business for more than 10 years If acquisition or public offering is planned» Start-ups Fair market value must use a reasonable application of a reasonable valuation method by a qualified person» Valuation must be updated annually or more often if significant business changes occur (financing round, government approval, etc.) Issues to consider» No bright line test, service can challenge» Size or dollar significance of option plan» Public companies are sensitive and want independent appraisals» Transactions typically require representation on 409A exposure» Make NQO compliant to 409A rather than exempt. Copyright All Rights Reserved. 12
13 Tax Considerations IRC Section 409A» IRS is starting to audit 409A compliance» Non-compliance Borne primarily on employees, compensation is taxable immediately Companies exposed to withholding tax, reporting violations 20% additional penalty (on value of compensation) Interest charged» Financial statement auditors are becoming more demanding in their requirements/documentation for 409A valuations» Stakeholders may not understand the meaning and financial impact of 409A valuation reports Copyright All Rights Reserved. 13
14 Impact of Granting Stock Options» Exposure to 409A compliance Ensure valuation procedures and personnel comply with regs» Will a new grant of stock options impact the decision to exercise my stock options? Dilution analysis» What is the value of my stock options at different company values and when to exercise stock options? Planning or scenario analysis» What is the impact of the development of secondary market platforms for selling stock options in the coming years? Copyright All Rights Reserved. 14
15 Impact of Next Round Financing» Valuation Challenges Associated with Preferred Stock: Non-Participating Receives liquidation preference (for example, 1 x initial investment) Fully participating receives liquidation preference, plus pro rata share of the proceeds of the company Capped participation with or without an option to convert into common shares Participating with a forced conversion» Best Practices: Simulations before signing terms sheets to optimize investment for founders and existing shareholders Simulations may have an impact of millions of dollars at future equity financing events or M&A Copyright All Rights Reserved. 15
16 Impact of M&A or IPO» When a company is sold, must allocate proceeds to the selling shareholders based upon different share classes Need to use valuation techniques to know how much goes to each class of shareholders Valuation reports for prior years will be scrutinized for any weaknesses that could leave the acquiring company exposed for tax and accounting issues Copyright All Rights Reserved. 16
17 Impact at M&A or IPO: The Exit Waterfall» Best Practices: Creating exit waterfalls for start-ups and emerging companies Will show amounts received ( payoff ) at various levels of company value Will illustrate in real terms the meaning of shareholder dilution to the founders of start-up companies Helps the parties to understand anti-dilution provisions, participation rights and liquidation preferences in corporate term sheets relating to new investments in the company ( economic rights ) Copyright All Rights Reserved. 17
18 Case Study Case Study for the Start-Up or Emerging Business Copyright All Rights Reserved. 18
19 Questions? Legal» Baden Gage & Schroeder, LLC and AlgoValue provide these materials as a general information service to clients and friends of Baden Gage & Schroeder, LLC. It should not be construed as legal advice on any subject matter and is for informational purposes only. IRS Circular 230» To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Mike Smith, ASA, CFA, CVA Senior Manager, Baden Gage & Schroeder, LLC Phone: msmith@badencpa.com Raphael Meyara CEO and Co-Founder, AlgoValue, Inc. Phone: (315) raphael@algovalue.com Gary Massey, CPA COO, AlgoValue, Inc. Phone: (404) gary@algovalue.com Copyright All Rights Reserved. 19
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