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Compensation: Restricted Stock Valuation Standards


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Discounting the Value of Publicly-traded Stock and Getting the IRS plus the SEC to accept it -

An Unique and not impossible Result !

When valuing incentive stock or stock options given to executives or to a member of a Company's Board of Directors, one should be familiar with the below 6 guideline references used by EMCO/Hanover, which the SEC and IRS have accepted as noted in the Case example below of a publicly traded stock selling then at $60 per share., in determining the price of a Company's restricted stock and what may or may not be a shortcoming in their application.

1.) Emerging Issues Task Force (EITF) 96-18: Accounting for Equity Instruments Issued to other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services; 2.) FASB Statement No. 123, Accounting for Stock-Based Compensation; and 3.) FASB No. 123 (revised 2004), Share-Based Payment; FASB Interpretation No. 28 :

Statement 123 establishes the measurement principles for transactions in which equity instruments are issued in exchange for the receipt of goods or services. Paragraph 8 of Statement 123 states that those transactions should be measured at the fair value of the consideration received or the fair value of the equity instruments issued, which is a more reliably measurement. However,Statement 123 does not prescribe the measurement date or provide guidance on recognition of the cost of those transactions. It further does not address the accounting for equity instruments issued in conjunction with selling goods or services, such as sales incentives.

One should also be aware that in IAS 39 Financial Instruments: Recognition and Measurement it states: "the best evidence of fair value is quoted prices in an active market. If the market for a financial instrument is not active, an entity establishes fair value by using a valuation technique. . . . . . A valuation technique (a) incorporates all factors that market participants would consider in setting a price and (b) is consistent with accepted economic methodologies for pricing financial instruments.

4.) Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans:

Here, the valuation methodology is fairly well defined. The fair value of an award is determined by using a pricing model. Permissible models include: the Black-Scholes model and a Lattice Model. FASB does not express a preference for a specific pricing model. The difference is their usage is that the Lattice Model can explicitly capture expected changes in dividends and stock volatility over the expected life of the options, in contrast to the Black-Scholes option-pricing model, which uses weighted average assumptions about option characteristics.

5.) SEC Staff Accounting Bulletin No. 57, Contingent Stock Purchase Warrants; and

6.) SEC Staff Accounting Bulletin No. 95 (untitled, which deletes SAB 57):

General Comment - #5 and #6, re: SEC Staff Accounting Bulletins Nos. 57 and 95 -

Per the SEC Manual: The statements in staff accounting bulletins are not rules or interpretations of the Commission nor are they published as bearing the Commission's official approval . They represent interpretations and practices followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the Federal securities laws. Specifically, why the below are not applicable in Elephant's case as it relates to issuing and valuing shares awarded Directors for services rendered:

Now let's take an actual example of a Company used by one of the top 10 Accounting Firms in the United States where the SEC approved in the application of the above, referencing each of the 6 key measurement requirements in determining the "fair" ("true") of a Company's Stcok for compensation and SEC reporting purposes:

Quoted OTC: BB Stock Price: $.60 but where the SEC accepted a price of $.22 in the pricing of both Directors' and Key Employeee Compensation Shares.

Company "A" as excerpted from the actual report filed with the Securities and Exchange Commission (SEC) and approved by the SEC

Company "A" (herein referred as the "Company") has requested that Mr. John Smith (herein also referred to as "Mr. Smith" or the "Undersigned") determine what value should be assigned to certain issued capital stock, legend as "restricted" under Rule 144 in Company A to its Directors, Officers and Employees at December 31, 2008.

Conclusion

Mr. Smith's opinion is that the fair value of Company "A" at December 30, 2008 was $.22 per share. See Pages 3 and 4 - Basis of A's Fair Value, not the reported OTC:BB price of $.60. A comparison was then made to the Liquidation Value of A which was around $.26 per share (Total Assets of $24,633,000 - Total Liabilities of $9,712,000 = $12,921,000/ shares outstanding of 50MM = $.26 per share.

A's Business

Company A is a proprietary service operator to the multi-media industry in the United States, Europe, Asia Pacific, and the Middle East. The Company provides traditional telecom, voice over Internet protocol, and media streaming services, as well as distribution services, including billing and collection primarily to the business-to-business community within the telecommunications market. Its products and services include traditional fixed line network-based services, such as carrier select and carrier pre-select services; service numbers/premium rate and toll free services; two-stage dialing; video and audio streaming; distribution of content driven services to end-users via PC, laptop, fixed telephone, or mobile handset using a software interface called media phone, which provides end-users access to content, including music, videos, and games, as well as VoIP communication services, and fax and SMS service; mobile services; and voice and data transmission, such as IDD and pre-paid calling cards services. The Company also develops in-house telecom and Media related systems and software. The Company was founded in 1994 and is based in the United States in the State of -------.

A's Estimated Revenue and EBIT, Fiscals 2008 and 2009 -
Continued operating losses estimated and a heavy dependence on its ability to attract new capital

As part of its valuation analysis, Mr. Smith reviewed Company A's anticipated operating results for Fiscal 2008 (December 31, 2008) and that projected for Fiscal 2009. With regard to the latter, Mr. Smith had the Company prepare a 3-level operating forecast based on the Company's "base" case, "medium" case and "best" case scenario. At the same time, Mr. Smith asked the Company for its realistic estimate of revenue and earnings for 2008 on an EBIT bases and without any consideration for an investment of minimally $6 million in new capital to $20 million. Given the Company's current capital position, Company A is anticipated to exhaust in current capital by the end of January, 2009 - mid-February, 2009.

Based on the availability of new capital, below are these estimates which are totally tied to the development of new business, none of which to date has come fully on stream: only the Customer B's contract, but yet to be fully operational, has recently been signed while a separate potentially large contract is still in negotiations - both of which are material in the attainment of even the "Base Case" projections given below.

  Base Case Medium Case Best Case
Fiscal 2008      
Revenues  $43.6 million $43.6 million $43.6 million
EBIT  <12.1Million>    <12.1Million>  <12.1 million>
Fiscal 2009      
Revenues  $53.million    $61.7million $102.4million
EBIT <6.4 million>  <4.7 million>  <1.9 million>

Note: A copy of the detailed 3-year operating projections above is on file in the Company's Central Accounting Offices. However, because new capital is needed, Mr. Smith chose to use only Fiscal 2009.

Conclusion : Management believes that its cash operating account will be in a negative position by mid-February, and thus, without the infusion of new capital (yet to be identified at the time of this opinion) it is Mr. Smith's opinion is that the Company is on the verge of Insolvency and even the value of its Intangible Assets, once estimated at $55 million but under a "going concern" concept could not sustain this. In Mr. Smith's opinion this rendered the current Closing Trading Price of its stock an "invalid" indicator of the Company's True Fair Value.

Further, given even the best of the Company's projections, noted above, Mr. Smith believes that the only indicator of the Company's True Fair Value is that as noted under its current Bid Price.

Specific Literature References In Valuing Publicly-Listed, Not Active Securities

There are six specific references/ guidelines used by accountants and investment bankers in the valuing publicly-listed securities. These include: 1.) Emerging Issues Task Force (EITF) 96-18: Accounting for Equity Instruments Issued to other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services; 2.) FASB Statement No. 123, Accounting for Stock-Based Compensation; and 3.) FASB No. 123 (revised 2004), Share-Based Payment; FASB Interpretation No. 28; 4.) Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans; 5.) SEC Staff Accounting Bulletin No. 57, Contingent Stock Purchase Warrants; and 6.) SEC Staff Accounting Bulletin No. 95 (untitled, which deletes SAB 57). Each are commented on below.

1.) Emerging Issues Task Force (EITF) 96-18: Accounting for Equity Instruments Issued to other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services; 2.) FASB Statement No. 123, Accounting for Stock-Based Compensation; and 3.) FASB No. 123 (revised 2004), Share-Based Payment; FASB Interpretation No. 28 ;

Statement 123 establishes the measurement principles for transactions in which equity instruments are issued in exchange for the receipt of goods or services. Paragraph 8 of Statement 123 states that those transactions should be measured at the fair value of the consideration received or the fair value of the equity instruments issued, which is a more reliably measurement. Statement 123 does not, however, prescribe the measurement date or provide guidance on recognition of the cost of those transactions. Also, it does not address the accounting for equity instruments issued in conjunction with selling goods or services, such as sales incentives.

Specific Reference Toa Valuing a Non-Active, Publicly-Traded Securities: The Fair Value Method

However, in IAS 39 Financial Instruments: Recognition and Measurement states: "the best evidence of fair value is quoted prices in an active market. If the market for a financial instrument is not active, an entity establishes "fair value" by using a valuation technique. . . . . .

A valuation technique (a) incorporates all factors that market participants would consider in setting a price and (b) is consistent with accepted economic methodologies for pricing financial instruments.

4.) Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans:

Here, the valuation methodology is fairly well defined. The fair value of an award is determined by using a pricing model. Permissible models include: the Black-Scholes model and a Lattice Model. FASB does not express a preference for a specific pricing model. The difference in their usage is that the Lattice Model can explicitly capture expected changes in dividends and stock volatility over the expected life of the options, in contrast to the Black-Scholes option-pricing model, which uses weighted average assumptions about option characteristics.

5.) SEC Staff Accounting Bulletin No. 57, Contingent Stock Purchase Warrants; and

6.) SEC Staff Accounting Bulletin No. 95 (untitled, which deletes SAB 57):

General Comment, re: SEC Staff Accounting Bulletins Nos. 57 and 95 -

Per the SEC Manual: The statements in staff accounting bulletins are not rules or interpretations of the Commission nor are they published as bearing the Commission's official approval . They represent interpretations and practices followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the Federal securities laws. Specifically, why the below are not applicable in Elephant's case as it relates to issuing and valuing shares awarded Directors for services rendered:

SEC Staff Accounting Bulletin No. 57, not applicable for it views concerning Accounting for Contingent Warrants in Connection with Sales Agreements with Certain Major Customers ... Directors' fees are for services rendered and are not Contingent Warrants in Connection with Sales Agreements with Certain Major Customers.

SEC Staff Accounting Bulletin No. 95 (which deletes SAB 57): Staff Accounting Bulletin No. 57 and concludes that the interpretative guidance providing for an intrinsic value measurement is no longer necessary due to the general guidance in FAS 123 that provides for fair value measurement for transactions with other than employees.

However, FAS 123 does not provide specific guidance on the methodology for determining fair value for such an arrangement or the measurement date on which the fair value of the equity instrument is determined. IAS 39 Financial Instruments does, as noted above.

Conclusion : Because of the above, Mr. Smith then decided to use A's Bid versus its Ask Price which it believed was the only barometer available to indicate A's true market value, given its current and projected loses plus heavy dependence for an infusion of new capital.

Basis of A's Fair Value

In arriving at this conclusion, Mr. Smith first analyzed the Company's stock trading activity, given its last 15 trading days (December 3rd through December 30, 2008). Specifically noted was that the price of A's stock ranged from $.56 to $.60 per share. However, during this period of time, only5 trades were concluded, representing a total of only 1,123 shares traded despite the fact that there are currently a total of some 55M shares outstanding with some 23% of that amount represented by the public float, consisting of between 4,000 -7,000 shareholders.

Because of this, Mr. Smith then turned to what A's Bid and Ask Price was on December 30th as a more indicative measurement of A's "Fair Value" than its Closing Price. On December 30th, there were 12 Market Makers, ranging in price between $.22 and $.0001 - of which Securities Company I Bid Price was $.22, Securities Company II was at $.11, Securities Company III was at $.10, Securities Company's IV was at $.10, Securities V at $.10 and Securities Company V was at $.05 were the top 6. Each was posted at 5,000 share bids, yielding an average of less than $.11 per share.

For conservative purposes Mr. Smith chose only to use the Bid Price as quoted by Securities Company I, namely $.22, even though by averaging the six top Market Makers ($.11 per above) it would had been even more realistic of A's "Fair Value."

Other Standard Valuation Methods -
In Mr. Smith's Opinion, Not APPLICALE in A's Case

Mr. Smith was not able to use any standard valuation methods, as defined under Revenue Ruling 59-60, except as noted under 123R herein, such as: The Price/Earnings Method, The Discounted Cash Flow Method, The Asset Method or a typical industry standard often referred to as The Revenue Method, which an independent research company used in its August, 2008 Research Report on Company A. The reasons underlying why it chose to use the Company's Bid Price in determining its Fair Value versus another method of valuation was as follows:

1.) In order to use the Price/ Earnings Method of Valuation, a Company has to be reporting positive net earnings, which Company A is not, or at least alternatively have evidence that pre-tax earnings on at least break-even basis has been or can be reached and thus, the reported latest months' earnings can be annualized. Company A could not meet this test. For Fiscal 2007 and again for 2008, Company A has or will report negative operating results in excess of $10 million per its fiscal year.

2.) In regard to The Discounted Cash Flow Method of Valuation, a company must prove that it can attained a positive cash flow if not in the current period, then at least in the foreseeable future. Company has not been able to do this either for its operating results to date and in the ensuing foreseeable future (fiscal 2009) show a need for new capital plus with its operations continued to be projected to produce both negative pre-tax earnings and a negative cash flow, coupled with further dependence in the future to require additional working capital. However, there is no certainty that such capital can be raised, particularly in these highly recessionary down market. Equally important is the fact that Company A has never attained the results projected in its Business Plan, missing 2008 alone by more than an estimated 30-40%, a key test in whether or not one can use The Discounted Cash Flow Method for that is totally dependent on one's ability to produce a positive cash flow which Company A has to date not demonstrated that it can.

3.) With regard to the third method of valuation, namely The Revenue Method (often referred to as an "Industry Standard Method of Valuation" based on "comparable companies" as used in the Independent's Research Report referenced prior - "Independent"), Company A can not currently use this method either for 95% of its revenue is currently derived from "ZERO" margin business, this making this standard non-usable. Further, A's very existence is totally dependent on its ability to raise new capital, which based on its last twelve months of negative cash flow ($1.2 million including CAPEX since the latter is a key element in obtaining new marginable profit customers) or $18 million ($1.2 million times 15 months) over the ensuing 15 month period in order to meet the basis for a non-qualified opinion, 12-months after the actual rendering of the certified accountant's opinion itself based on prior year's fiscal operating results.

4.) On the Asset Method of Valuation (with estimated Net Assets projected at December 31, 2008 to be approximately $10 million), A's estimated Fair Value exceeds this Method and thus it is not indication of ETAK's current valuation.

Conclusion : $.22, not the OTC:BB price of $.60 as prior noted which was accepted and approved by the SEC involving a 63% discount to market.

In a second company, EMCO/ Hanover was recently able to discount another OTC publicly-traded stock by 60% which was again accepted by the SEC and the IRS. So, it can be done despite the Service's preference of only using a quoted price of a publicly-traded security. Remember an appraiser's credentials (see: www.emcohanover.com) and detailed analyses are the critical factor for acceptance.

For any questions or inquiries, call Bruce Barren at (310) 405-3393.

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