EXECUTIVE EDUCATION SERIES: Accounting and Finance Issues of

Technology Companies

Presented by: James Comito and Tim Woods Mayer Hoffman McCann P.C., An Independent CPA Firm

June 27, 2013

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Before We Get Started…

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This webinar is eligible for CPE credit. To receive credit, you will need to answer periodic polling questions throughout the webinar.

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CPE Credit

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The information in this Executive Education Series

course is a brief summary and may not include all the details relevant to your situation.

Please contact your MHM service provider to further

discuss the impact on your financial statements.

Disclaimer

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Today’s Presenters

James Comito, CPA Shareholder 858.795.2029 | jcomito@cbiz.com A member of MHM’s Professional Standards Group, James has expertise in all aspects of revenue recognition, business combinations, impairment of goodwill and other intangible assets, accounting for stock-based compensation, accounting for equity and debt instruments and other accounting issues. Additionally, he has significant experience with a variety of other regulatory and corporate governance issues pertaining to publicly traded companies, including all aspects of internal control. In addition, James frequently speaks on accounting and auditing matters at various events for MHM.

Tim Woods, CPA Shareholder 720.200.7043 | twoods@cbiz.com A member of MHM’s Professional Standards Group, Tim is a subject matter expert for derivatives and hedge accounting. He also has extensive experience in leasing transactions, fair value, stock-based compensation, and complex debt and equity transactions. Tim has worked in public accounting, consulting, and private industry for the past 20 years, focusing on outsourced CFO consulting and financial statement audits for small and mid size privately held companies. He has extensive experience in accounting for business combinations and variable interest entities, as well as with issues in leasing, revenue recognition, and foreign exchange.

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Today’s Agenda

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Common accounting and finance issues faced by companies in the technology industry

Sources of capital and the pros and cons of each 3

Valuation of a company and its equity

COMMON ACCOUNTING AND FINANCE ISSUES FACING THE

TECHNOLOGY INDUSTRY

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For most technology companies, particularly those early in their development, raising capital is an ongoing process that requires a significant investment of time and effort by the accounting and finance department.

The choice between raising capital through the issuance of equity or debt is dependent on a variety of factors. Sometimes an entity does not completely control the form of the capital raise (e.g., terms are dictated by the investor).

Financial instruments commonly used to raise capital typically include various terms and conditions; and the related accounting issues that stem from such terms and conditions can be complex.

Raising Capital

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Many financial instruments have characteristics of both debt and equity. For a company that is attempting to reduce its leverage straight debt or convertible debt is less attractive than an instrument that can be classified as equity under today's accounting guidance.

The accounting requirements surrounding these “hybrid” instruments had been described as similar to traveling the “Bermuda Triangle” — you go into the literature and sometimes you don’t come out!

Raising Capital

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Whenever a financial instrument is required to be settled with cash; liability treatment is the likely the resulting accounting classification.

If a financial instrument is required to be classified as a “liability,” the accounting is at fair value and will have to be remeasured each reporting period.

Raising Capital – Basic Concepts

Example: A financial instrument that has a single settlement alternative (in cash) on a specific date. Such instruments may come “cloaked” in the form of a preferred security; however, they are in substance the same as debt

and are accounted for as such.

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Some financial instruments are both redeemable and convertible. In this case, the redemption is not an unconditional obligation to settle the instrument in cash on a specific date (because the holder could elect to convert the instrument to equity). Provided other requirements are met, this type of instrument could be classified within equity as long as the conversion feature is outstanding and considered substantive.

Raising Capital – Redemption vs. Conversion

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Many financial instruments are structured to allow the holder to choose between settling the financial instrument in cash or converting the instrument to equity. Many investors want to protect themselves against a down turn in the investee’s business by negotiating what is known as “down round” protection. In this type of situation, a future sale of equity at a price

lower than the investor’s initial conversion price triggers a “reset” of the conversion price to match the new lower price of the latest equity round.

Frequent Problem with Conversion Features

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The down round protection provision is commonly identified as anti dilution protection, however, it is a common violation of the accounting guidance that requires a conversion feature to relate to a fixed number of shares at a fixed price (fixed for fixed) to qualify for equity classification.

Frequent Problem with Conversion Features

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Often the most important accounting measurement found in a GAAP set of financial statements.

Significant complexity still exists related to revenue recognition; however, recent guidance has been issued that is very helpful to many technology companies that utilize multiple element arrangement.

Relief from the stringent software accounting requirements has been issued for certain tangible products that contain software.

Revenue Recognition

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Revenue Recognition

Multiple Element Arrangements

• ASU 2009-13 amends FASB ASC 605, Revenue Recognition, 25, “Multiple-Element Arrangements” (formerly EITF Issue 00-21)

Software Revenue Recognition Guidance

• ASU 2009-14 amends FASB ASC 985, Software, 605, “Revenue Recognition”, (formerly AICPA SOP 97-2)

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The prevalence of arrangements with multiple deliverables has significantly increased as customers demand integrated solutions for their needs.

In a typical multiple element arrangement, the vendor often receives an up-front payment for the delivery of a tangible product (or licensing of technology) and receives subsequent payments as additional services are provided to the customer (e.g., training and installation, etc.)

Background

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Selling Price Hierarchy VSOE (vendor-specific objective evidence)

The price charged when the same element is sold separately or, for an element not yet sold separately, the price established by management with the relevant authority.

TPE (third-party evidence) Competitors’ sales prices for the same or largely interchangeable

products or services to similar customers in stand-alone sales (if VSOE is not available).

Best estimate of selling price Used in the absence of both VSOE and TPE

Remember – Standalone value must still be established to qualify for a separate unit of accounting.

Revenue Recognition – Non-Software

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Software-enabled devices/products are often sold with undelivered elements for which VSOE is not available. In manner similar to non software multiple element arrangements, revenue recognition did not always represent the underlying economics of the arrangement(s).

In essence, the Task Force recognized the similarity of many products containing software to the products covered by ASU 2009-13 which led to the aforementioned decision to amend the scope of ASC 985-605

Revenue Arrangements That Include Software Elements

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The general intent of ASU 2009-14 is that tangible products with software components that work together to deliver the product’s essential functionality should be considered non-software deliverables; therefore, subject to the less stringent separation guidance in ASU 2009-13.

Revenue Arrangements That Include Software Elements

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Scope of the software guidance is amended to exclude: Software components of tangible products that are sold, licensed,

or leased with tangible products when the software components and non-software components of the tangible products function together to deliver the tangible product’s essential functionality.

If this definition is met, both the software and non-software components are scoped out of the software guidance. Undelivered elements that relate to software essential to the tangible products functionality are similarly excluded from the scope of the software guidance.

Revenue Arrangements That Include Software Elements

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The fair value of a company’s common stock is an important input to the Black Scholes option pricing model typically used by technology companies to value their option grants.

Many private companies have not established a process to determine the value of its common stock which can lead to issues related to the accounting for share-based payment awards.

While an independent appraisal is always a good idea, a thoughtful process that considers all available evidence (both positive and negative) related to common stock valuation may be helpful in determining the accounting impact related to share-based payment awards.

Share-Based Compensation

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The general issue is whether the capitalization of research and development costs is permitted. Generally, current accounting guidance does not permit the capitalization of R&D except under limited conditions.

Software vendors have very specific accounting guidance related to the development of software for sale to third parties. This guidance is not optional although in practice it sometimes seems as though it were.

Research and Development

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In general, companies that reside in the technology industry are subject to the same issues related to fair value measurements as other industries. The guidance pertaining to fair value measurements has been difficult to implement in practice.

Impairment of intangible assets is often cited as an accounting issued faced by technology companies. Often an income approach is used to develop an estimate of fair value. This approach requires an estimate of future cash flows which include future sales. The very nature of the technology industry makes such predictions even more difficult than usual. Recent alternative accounting proposed by the PCC may help to ease the burden.

Fair Value Measurements

VALUATION OF A COMPANY AND ITS EQUITY

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Required (for accounting and finance purposes) under the following circumstances (not all inclusive): The company is in the process of issuing equity for

purposes of raising capital; The company is in the process of issuing stock based

compensation; and The company is in the process of issuing equity in exchange

for an asset, the satisfaction of a liability, or for the equity of another company.

Valuation of a Company’s Equity

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Valuing a Company’s Equity

The determination of the methods, or combination thereof, to utilize when valuing a company’s equity can be significantly impacted by the size of the company and its capital structure.

Furthermore, the valuation of a company’s equity is a measurement at a point in time and represents an estimate for accounting purposes; unless the equity is sold for cash consideration — in which case the value of the equity has been determined, assuming this occurred in an arm’s length transaction. If the company has sold its equity in an arm’s length transaction, and

this transaction occurred in reasonable proximity to the non-cash transactions involving the company’s equity, and there have not been material changes to the company’s operations and/or financial structure, then it is reasonable to assume that the value of the equity as determined by this transaction is a reasonable estimate of the value of the company’s equity in a subsequent non-cash issuance of equity.

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Valuing a Company’s Equity

Three methods for valuing a company and its equity:

Income-Based Method

• Discounted cash flows

Market-Based Method

• Comparable companies and their respective valuations as they can be determined in terms of multiples of sales, EBITDA, earnings, etc.

• Would include past transactions (sales) of the Company’s equity

Cost Replacement Method

• What would it cost to replicate current operational, financial and intangible structure?

Pursuant to ASC 820, Fair Value Measurements, all three methods must be considered in the determination of the valuation of a company, and its equity.

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Valuing a Company’s Equity

A valuation of a company’s equity can take into account the results of all three methods to arrive at a reasonable estimate of the Company’s equity.

For example, a SAAS company may determine that its equity has a value of $40,000,000 based upon a discounted cash flow analysis, a $30,000,000 value based upon a peer multiple of EBITDA of 6 times, and a value of $20,000,000 based upon a cost replication approach. The company may then determine that a reasonable valuation is

$32,500,000 based upon using a 75% weighting of the market based approach and a 25% weighted of the income approach (DCF). In this case the company does not believe that a cost replication approach properly captures the inherent value of the company’s equity and has therefore excluded this approach from its determination of the company’s value.

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Valuing a Company’s Equity — Considerations

For an income approach (DCF), the valuation is only as good as the reliability of the estimated cash flows.

Therefore, the estimates should be based on a trend of historical data that sufficiently takes into account all currently known information as well as projections of growth rates that are based on reasonable expectations.

A DCF model is typically 5 years with a terminal value determined at the end of the 5 years using a Gordon Growth Model (terminal cash flow / (discount rate – growth rate).

Clearly, the rate at which the estimated cash flows are discounted will have a material impact on the valuation of the company.

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Valuing a Company’s Equity — Discount Rate

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The cash flows should be discounted at the company’s Weighted Average Cost of Capital (WACC); or if we assume no debt in the capital structure, we exclude interest expense, and utilize the Company’s cost of equity.

There is a great deal of guidance and theory on the appropriate discount rate to utilize; however, the rule of thumb for the cost of equity is that rate that a current investor will require over the holding period to invest in the Company’s equity. Clearly the risk of the investment dictates this rate which takes

into account many factors including the size of the company, the capability of management, control premiums, minority interests, etc…

SOURCES OF CAPITAL AND THE PROS AND CONS OF EACH

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Sources of Capital

Sources of capital available to companies: (in order of the company’s life cycle) Companies typically are initially funded by a group of investors that are labeled

as Friends and Family. Companies then move to Angel Investors which are accredited investors that

invest their own money; there are angel groups that often pool their money together to invest in companies. Angel investors typically invest in seed rounds of companies and may continue to participate or be brought in in A rounds (although this is rare).

Venture Capital Firms may invest aside angel investors in A rounds and will typically continue to fund companies as they grow throughout successive rounds of financing (B-D, etc…)

As the Company grows its EBITDA and gets to ay least $1M per year, certain Micro Private Equity Firms will invest in companies this size. However, it is more likely that the firm has $3-$5M of EBITDA before a middle market PE firm will take interest. The middle market PE firm will then sell the company upon its continued growth to a larger PE Firm, Strategic Buyer, or in an IPO.

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Sources of Capital

Sources of capital available to companies: (in order of the company’s life cycle) Public equity, that is, taking a company public in an IPO, is a source of

financing that is available to promising technology companies. However, it is a process that must be thoroughly conceived and planned, and has lost a lot of its luster given the burgeoning private equity industry and the expense of being a public company.

Bank debt in the form of lines of credit and term debt, can be made available to companies that have the proven ability to pay back the loans. Debt has always been a cheaper source of capital than equity, provided that the Company can qualify for the loan.

Public debt — reserved for large companies that have the need for large amounts of debt.

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Sources of Capital – Angel Investors

PROS Can provide the needed capital for a startup Ability to raise capital in small amounts (founder control) Flexible business agreements Can bring forth vast knowledge and experience to a new

company Involved in high risk investments

CONS Rarely make follow-on investments Can actually be deceptive Can be costly — expect a high rate of return – 25%+ Active company involvement can lead to problems Do not have national recognition

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Sources of Capital – Venture Capital

PROS Firms have deep pockets. Average investment is between

$500,000 and $5 million. Access to knowledgeable and experienced consultants to help

guide and grow the firm Many deep-pocketed friends of the firm that have access to

additional capital

CONS Long process of due diligence – 6-12 months or more Expect large returns – much larger than typical angel investors –

50%+ and therefore seek to price their deals accordingly (valuation concerns – not called “vulture” capital for nothing)

Want equity and may want control of the company

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Sources of Capital – Private Equity

PROS Can revive a dying division in an organization Plays a useful role as a corporate scavenger/recycler The PE model can make for better governance Access to expertise and synergies with other PE companies Goal is to increase the value of the company

CONS Sheds assets and destroys jobs May replace management Excessive leverage — LBOs are very common Funds charge management fees to companies Most likely want control of the company

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Sources of Capital – IPO

PROS The company will improve its financial condition by obtaining money

that does not have to be repaid. Stock in the company can be used in part to finance acquisitions of

other companies (i.e. part of the purchase price can be paid in stock). The public market for the company's shares provides an irrefutable

valuation of the company on a daily basis. The company obtains increased prestige and visibility. Shareholders of the company benefit from holding shares that are,

subject to certain restrictions, freely marketable and usable as collateral for loans.

Shares that are publicly traded generally command higher prices than shares that are not publicly traded.

Shareholders are able to diversify their investment portfolios, due to the increased marketability of their shares.

Management in publicly held companies is generally compensated at a higher level than management of private companies.

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Sources of Capital – IPO

CONS Management loses some of its freedom to act without board approval and

approval of a majority of the shareholders in certain matters. Shareholders tend to judge management in terms of profits, dividends and

stock prices. This can cause management to emphasize short-term strategies rather than long-term goals.

The cost of an initial public offering is substantial, in the form of underwriter's commissions and expenses, legal and accounting fees, printing costs, and registration fees.

SEC requirements to reveal sensitive information on an ongoing basis, including business strategies, financial results, and executive salaries and compensation arrangements.

The company is required to have its financial statements audited on a regular basis.

Continuing costs for periodic reports and proxy statements that are filed with the regulatory agencies and distributed to the shareholders.

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Sources of Capital – IPO

CONS (cont.) A substantial portion of management time must be dedicated to initial and

ongoing reporting requirements of regulatory agencies rather than to management of the company's operations.

Management and accounting information systems often must be upgraded. Management's marketability of shares is partially constrained by

prohibitions on insider trading, prohibitions on short-sales and classification of their shares as restricted securities.

Control of the company, as well as management positions, can be taken away from existing management if a dissident investor or group of investors obtains majority control. Liability for Officers and Board Members is increased.

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Questions?

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Join us for these future webinars 7/16: Is a Simpler Accounting Framework in the Future for

Private Companies? 9/5: Third Quarter Accounting and Financial Reporting

Issues Update 10/17: Revenue Recognition for Life Sciences Companies

If You Enjoyed This Webinar…

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Today’s Presenters

James Comito, CPA Shareholder 858.795.2029 | jcomito@cbiz.com A member of MHM’s Professional Standards Group, James has expertise in all aspects of revenue recognition, business combinations, impairment of goodwill and other intangible assets, accounting for stock-based compensation, accounting for equity and debt instruments and other accounting issues. Additionally, he has significant experience with a variety of other regulatory and corporate governance issues pertaining to publicly traded companies, including all aspects of internal control. In addition, James frequently speaks on accounting and auditing matters at various events for MHM.

Tim Woods, CPA Shareholder 720.200.7043 | twoods@cbiz.com A member of MHM’s Professional Standards Group, Tim is a subject matter expert for derivatives and hedge accounting. He also has extensive experience in leasing transactions, fair value, stock-based compensation, and complex debt and equity transactions. Tim has worked in public accounting, consulting, and private industry for the past 20 years, focusing on outsourced CFO consulting and financial statement audits for small and mid size privately held companies. He has extensive experience in accounting for business combinations and variable interest entities, as well as with issues in leasing, revenue recognition, and foreign exchange.

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