2.12 Escrowed Share Arrangements

ASC 718-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Escrowed Share Arrangements and the Presumption of Compensation

S99-2 This SEC staff announcement provides the SEC staff’s views regarding Escrowed Share Arrangements and the Presumption of Compensation.

The SEC Observer made the following announcement of the SEC staff’s position on escrowed share arrangements. The SEC Observer has been asked to clarify SEC staff views on overcoming the presumption that for certain shareholders these arrangements represent compensation.

Historically, the SEC staff has expressed the view that an escrowed share arrangement involving the release of shares to certain shareholders based on performance-related criteria is presumed to be compensatory, equivalent to a reverse stock split followed by the grant of a restricted stock award under a performance-based plan.FN1

When evaluating whether the presumption of compensation has been overcome, registrants should consider the substance of the arrangement, including whether the arrangement was entered into for purposes unrelated to, and not contingent upon, continued employment. For example, as a condition of a financing transaction, investors may request that specific significant shareholders, who also may be officers or directors, participate in an escrowed share arrangement. If the escrowed shares will be released or canceled without regard to continued employment, specific facts and circumstances may indicate that the arrangement is in substance an inducement made to facilitate the transaction on behalf of the company, rather than as compensatory. In such cases, the SEC staff generally believes that the arrangement should be recognized and measured according to its nature and reflected as a reduction of the proceeds allocated to the newly-issued securities.FN2, 3

The SEC staff believes that an escrowed share arrangement in which the shares are automatically forfeited if employment terminates is compensation, consistent with the principle articulated in paragraph 805-10-55-25(a).

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FN1 Under these arrangements, which can be between shareholders and a company or directly between the shareholders and new investors, shareholders agree to place a portion of their shares in escrow in connection with an initial public offering or other capital-raising transaction. Shares placed in escrow are released back to the shareholders only if specified performance-related criteria are met.

FN2 The SEC staff notes that discounts on debt instruments are amortized using the effective interest method as discussed in Section 835-30-35, while discounts on common equity are not generally amortized.

FN3 Consistent with the views in paragraph 220-10-S99-4, SAB Topic 5.T., Accounting for Expenses or Liabilities Paid by Principal Stockholder(s), and paragraph 220-10-S99-3, SAB Topic 1.B., Allocation of Expenses and Related Disclosure in Financial Statements of Subsidiaries, Divisions or Lesser Business Components of Another Entity, the SEC staff believes that the benefit created by the shareholder’s escrow arrangement should be reflected in the company’s financial statements even when the company is not party to the arrangement.

As part of completing an IPO or other financing, certain shareholders who are also key employees of an entity may agree to place in an escrow account a portion of their shares, which would be released to them upon the satisfaction of a specified condition. In many of these arrangements, the shares are released only if the employee shareholders remain employed for a certain period or the entity achieves a specified performance target, and services from the employee shareholders may be explicitly stated in the arrangement or implicitly required in accordance with a performance target.

Arrangements with similar economics may be structured without a requirement for a formal escrow account. For example, instead of legally requiring outstanding shares to be held in escrow, the terms of an arrangement may specify that some or all of the shares are subject to forfeiture or repurchase at a nominal amount if specified performance conditions are not met or the employee shareholder does not remain employed for a certain period. We believe that the absence of a formal escrow account does not change the economics of an arrangement and that, in a manner consistent with the SEC staff’s views, such arrangements should be evaluated and accounted for in accordance with the guidance on escrowed share arrangements in ASC 718-10-S99-2.

As indicated in ASC 718-10-S99-2, the SEC staff has historically expressed the view that these escrowed share arrangements (including similar arrangements without a formal escrow account) are presumed to be compensatory and equivalent to reverse stock splits followed by the grant of restricted stock, subject to certain conditions (e.g., service, performance, or market conditions). This view reflects the arrangements’ substance, which is that the grantee’s unconditional equity interest is effectively reduced up front without consideration and the escrowed shares are returned (or reissued) only upon satisfaction of specified conditions. If the release of shares is tied to continued employment, the presumption cannot be overcome. In addition, even if the entity is not directly a party to the arrangement (e.g., when the arrangement is only between shareholders and new investors), the arrangement should be reflected in the entity’s financial statements.

However, the SEC staff has stated that in certain circumstances, the presumption can be overcome that an arrangement is compensation. To identify those circumstances, an entity should assess the substance of the escrowed share arrangement to determine whether it was “entered into for purposes unrelated to, and not contingent upon, continued employment.” For example, as a result of concerns related to the entity’s value, investors may require certain shareholders to participate in an escrowed share arrangement before the entity can raise financing. Further, investors may require the entity to achieve certain performance targets (e.g., an EBITDA target over a specified period) before the shares can be released. If the arrangement also requires continued employment, the arrangement is considered compensatory. However, if continued employment is not required (either explicitly or implicitly), the entity should consider all relevant facts and circumstances to determine whether the substance of the arrangement is unrelated to employee compensation.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.