1. Valuations and Equity Awards October 14, 2014 Robert W. McDonald @RWM

2. ME BRAND Account Executive on Skittles and Starburst for TBWA\Chiat\Day New York. LAWYER Securities and Corporate Attorney at Taft Stettinius and Hollister LLP START-UPS Co-Founder at The Brandery.

3. Start-Ups Need People

4. Equity Awards Nonqualified Stock Options: Stock options that do not qualify as incentive stock options. Ordinary income treatment. Incentive Stock Options: Qualify for certain special tax benefits under section 422 of the IRC. Capital gains treatment if holding periods met. Restricted Stock: Actual stock issuances subject to buy-back rights. Phantom Equity: Contractural award of economic benefits as if stock award was made.

5. Equity Awards Stock Appreciation Rights: Like a stock option but do not need to pay an exercise price. Profits Interests Units: Analogous to a stock appreciation right. General Terms: Almost always vesting over 4 years (monthly or quarterly) with a 1 year cliff. Double-trigger acceleration Short story: Use the most tax efficient equity award.

6. Incentive vs. Non-Qualified If shares acquired upon exercise of an ISO are held for more than one year after the date of exercise of the ISO and more than two years after the date of grant of the ISO, any gain or loss on sale or other disposition will be long-term capital gain or loss Other ISO Requirements ISO’s can’t be transferred except at death Must be granted to employees $100,000 limit on ISO awards during calendar year per employee Must be granted w/in 10 years of plan Exercised w/in 10 years of grant Exercised w/in 3 months of termination of employment

7. Use of Financial Valuations More often than not we use Profits Interests awards for LLC’s and Incentive Stock Options for Corporations. Consequently, we need to use the company’s financials to determine a valuation for the awards. For LLC’s, valuation can be ascertained by Board in good faith (though often hire third-party valuation experts) For corporations, valuation “requires a reasonable application of a reasonable valuation method.”

8. A VC Start-Up Income Statement

9. 409A 26 U.S. Code § 409A of the Internal Revenue Code: Regulates the treatment for federal income tax purposes in the United States of nonqualified deferred compensation paid by a "service recipient" to a "service provider“ (effective as of January 1, 2005). Internal Revenue Bulletin 2007-19 - March 7, 2007 provides the meat Requires a “reasonable application of a reasonable valuation method” A valuation needs to be performed by someone who is qualified (based on their knowledge, training, experience, etc.).

10. Fair Market Value The amount at which the property would change hands between a willing buyer and a willing seller, when the former is not under compulsion to buy and the latter is not under compulsion to sell, both parties having reasonable knowledge of the relevant facts.

11. Better Do It The Risks Far Outweigh the Costs Exercise price must be at or above the fair market value on the date the grant is made. Penalties: Immediate tax upon vesting (as opposed to exercise/sale) 20% additional federal penalty (on top of applicable federal ordinary income and state taxes) Costs between $2,500 - $10,000

12. Valuation Guidelines 409A Valuation Guidelines Exercise price must be at or above the fair market value on the date the grant is made. Penalties: Immediate tax upon vesting (as opposed to exercise/sale) 20% additional federal penalty (on top of applicable federal ordinary income and state taxes) Costs between $2,500 - $10,000

13. Valuation Guidelines General Valuation Guidelines the value of tangible and intangible assets of the company; the present value of anticipated future cash-flows of the company; the market value of stock or equity interests in similar companies and other entities engaged in trades or businesses substantially similar to those engaged in by the company recent arm’s length transactions involving the sale or transfer of such stock or equity interests; and other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders or its creditors

14. Methods Discounted cash flow method: benefit of ownership is the cash received. Market/Current value method: the cost paid in the last round of financing. This includes analysis of any secondary activity (buy-out of 1 employee?). Black Scholes OPM method: allocate value to capital structure based on Black Scholes option pricing model. Expected return: projection of a probable liquidity event. Comparable Companies: very difficult to find good comparables for early- stage businesses

15. Discounts Weighted Some valuations will choose one method (rarely). More frequently, the valuation will weight the various methods. Discounts Lack of Marketability Discounts (DLOM): Marketability is defined as the ability to convert an investment into cash quickly at a known price and with minimal transaction costs. The DLOM is a downward adjustment to the value of an investment to reflect its reduced level of marketability. Comparison of open market stock prices to restricted off-market stock prices. Minority Interest Discounts: A minority discount is the reduction applied to the valuation of a minority equity position in a company due to the absence of control. Not applied more recently.

16. Board Approval The last step of the process is to review the report and ensure factual accuracy. Board must approve the valuation for use for each award Bring-down of Valuation When material events occur, a new valuation is required Cheaper and easier to do a bring-down of current valuation than a new valuation Board must approve bring down valuation

17. THANK YOU Robert W. McDonald rob@brandery.org rmcdonald@Taftlaw.com @RWM