4.12 Valuation of Nonpublic Entity Awards
ASC 718-10
Fair-Value-Based
30-2 A share-based payment
transaction shall be measured based on the fair value (or in
certain situations specified in this Topic, a calculated
value or intrinsic value) of the equity instruments
issued.
ASC 718 identifies three ways for a nonpublic entity to measure share-based payment awards:
- By using fair value, which is the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties; that is, other than in a forced or liquidation sale.
- By using a calculated value, which is a measure of the value of a stock option or similar instrument determined by substituting the historical volatility of an appropriate industry sector index for the expected volatility of a nonpublic entity’s share price in an option-pricing model. See Section 4.13.2.
- By using intrinsic value, which is the amount by which the fair value of the underlying stock exceeds the exercise price of an option or similar instrument. See Section 4.13.3.
Nonpublic entities should make an effort to value their equity-classified awards
by using a fair-value-based measure. A nonpublic entity may look to recent sales of
its common stock directly to investors or common stock transactions in secondary
markets. However, observable market prices for a nonpublic entity’s equity shares
may not exist. In such an instance, a nonpublic entity could apply many of the
principles of ASC 820 to determine the fair value of its common stock, often by
using either a market approach or an income approach (or both). A “top-down method
may be applied,” which involves first valuing the entity, then subtracting the fair
value of debt, and then using the resulting equity valuation as a basis for
allocating the equity value among the entity’s equity securities. While not
authoritative, the AICPA’s Accounting and Valuation Guide Valuation of Privately-Held-Company
Equity Securities Issued as Compensation (the AICPA
Valuation Guide)4 emphasizes the importance of contemporaneous valuations from independent
valuation specialists to determine the fair value of equity securities.
4.12.1 Cheap Stock
The SEC often focuses on “cheap stock”5 issues in connection with a nonpublic entity’s preparation for an IPO. The
SEC staff is interested in the rationale for any difference between the fair
value measurements of the underlying common stock of share-based payment awards
and the anticipated IPO price. In addition, the SEC staff will challenge
valuations that are significantly lower than prices paid by investors to acquire
similar stock. If the differences cannot be reconciled, a nonpublic entity may
be required to record a cheap-stock charge. Since share-based payments are often
a compensation tool to attract and retain employees or nonemployees, a
cheap-stock charge could be material and, in some cases, lead to a restatement
of the financial statements.
An entity preparing for an IPO should refer to paragraph 7520.1 of the SEC Division
of Corporation Finance’s Financial Reporting Manual (FRM), which outlines
considerations for registrants when the “estimated fair value of the stock is
substantially below the IPO price.” In such situations, registrants should be
able to reconcile the change in the estimated fair value of the underlying
equity between the award grant date and the IPO by taking into account, among
other things, intervening events and changes in assumptions that support the
change in fair value.
The SEC staff has frequently inquired about a registrant’s
pre-IPO valuations. Specifically, during the registration statement process, the
SEC staff may ask an entity to (1) reconcile its recent fair values with the
anticipated IPO price (including significant intervening events), (2) describe
its valuation methods, (3) justify its significant valuation assumptions, and
(4) discuss the weight it gives to stock sale transactions. We encourage
entities planning an IPO in the foreseeable future to use the AICPA Valuation
Guide6 and to consult with their valuation specialists. Further, they should
ensure that their pre-IPO valuations are appropriate and that they are prepared
to respond to questions the SEC may have during the registration statement
process.
The AICPA Valuation Guide highlights differences between pre-IPO and post-IPO
valuations. One significant difference is that the valuation of nonpublic entity
securities often includes a DLOM. The DLOM can be determined by using several
valuation techniques and is significantly affected by the underlying volatility
of the stock and the period the stock is illiquid.
The AICPA Valuation Guide describes three foundational methods for estimating the
DLOM: the protective put model, the Longstaff model, and the quantitative
marketability discount model. However, it is assumed under the Longstaff model
that the investor is able to perfectly time the market and therefore maximize
proceeds. Since an investor typically does not have that timing ability, the
Longstaff model is generally not appropriate to use. In addition, use of the
quantitative marketability discount model may not be appropriate for complex
capital structures or when it is assumed that there are long holding periods.
While all put-based methods may have limitations, the protective
put model, also known as the Chaffee model or European7 protective put model, is widely used to calculate the DLOM. Entities
perform the calculation on the basis of an at-the-money put with a life equal to
the period of restriction, divided by the marketable stock value. The following
are two commonly used variations of the protective put model:
- Finnerty model — Under this model, also known as the average-strike put option model, an entity estimates the DLOM as an average-strike Asian8 put which measures the difference between the average price over the holding period and the final price.
- Asian protective put model — Under this model, an entity estimates the DLOM as an average-price Asian put that measures the difference between the current price and the average price over the holding period. The Asian protective put model results in DLOMs that are lower than those calculated under the protective put model and, for low volatility stocks, those calculated under the Finnerty model. For high volatility stocks, it results in DLOMs that are higher than those calculated under the Finnerty model.
4.12.2 ISOs, NQSOs, and Internal Revenue Code Section 409A
When granting share-based payment awards, a nonpublic entity should be mindful of
the tax treatment of such awards and the related implications. Section 409A of
the Internal Revenue Code (IRC) contains requirements related to nonqualified
deferred compensation plans that can affect the taxability of holders of
share-based payment awards. If a nonqualified deferred compensation plan (e.g.,
one issued in the form of share-based payments) fails to comply with certain IRC
rules, the tax implications and penalties at the federal level (and potentially
the state level) can be significant for holders.
Under U.S. tax law, stock option awards can generally be categorized into two groups:
- Statutory options, including incentive stock options (ISOs) and ESPPs that are qualified under IRC Sections 422 and 423, respectively. The exercise of an ISO or a qualified ESPP does not result in a tax deduction for the entity unless the employee or former employee makes a disqualifying disposition. While an ISO may result in favorable tax treatment for the recipient, certain eligibility conditions must be met.
- Nonstatutory options (also known as NQSOs or NSOs). The exercise of an NQSO results in a tax deduction for the issuing entity that is equal to the intrinsic value of the option when exercised.
The ISOs and ESPPs described in IRC Sections 422 and 423, respectively, are
specifically exempt from the requirements of IRC Section 409A. Other NQSOs are
outside the scope of IRC Section 409A if certain requirements are met. One
significant requirement is that the exercise price must not be below the fair
market value of the underlying stock as of the grant date. Accordingly, it is
imperative to establish a supportable fair market value of the stock to avoid
unintended tax consequences for the issuer and holder. While IRC Section 409A
also applies to public entities, the valuation of share-based payment awards for
such entities is subject to less scrutiny because the market prices of the
shares associated with the awards are generally observable. Among other details,
entities should understand (1) which of their compensation plans and awards are
subject to the provisions of IRC Section 409A and (2) how they can ensure that
those plans and awards remain compliant with IRC Section 409A and thereby avoid
unintended tax consequences of noncompliance.
A company’s failure to comply with the requirements in IRC
Section 409A related to nonqualified deferred compensation plans may affect how
the fair value of existing and future share-based compensation is determined and
how those awards are taxed. Specifically, if the form and operation of
compensation arrangements do not comply with the requirements in IRC Section
409A, service providers will be required to include the compensation in their
taxable income sooner than they would need to under general tax rules (e.g.,
vesting as opposed to exercise of an option) and service providers will be
subject to an additional 20 percent federal income tax plus interest on the
amount included in their taxable income. Although the tax is imposed on the
individuals receiving the compensation, in certain instances, an entity may
decide to pay the additional tax liabilities on behalf of its employees. Among
IRC Section 409A’s many requirements, valuation of the stock on the grant date
is critical, and grantees should establish the fair market value of their shares
to ensure compliance with IRC Section 409A. Both nonqualified and statutory
options are subject to IRC Section 409A unless they otherwise meet its criteria
for treatment as exempt stock rights. It is important for an entity to consult
with tax advisers regarding the tax effects of both existing and planned
share-based compensation plans to determine whether it is subject to the
requirements in IRC Section 409A or other IRC sections.
In addition, when recognizing compensation cost, many nonpublic entities use
their IRC Section 409A assessments to value their share-based payments. Because
those assessments are used for tax purposes, nonpublic entities should carefully
consider whether they are also appropriate for measuring share-based payment
awards under ASC 718.
See Chapter 10 of Deloitte’s Roadmap
Income
Taxes for a discussion of the income tax effects of
share-based payments.
4.12.3 Purchases of Shares From Grantees
4.12.3.1 Entity Purchases of Shares From Grantees
ASC 718-20
Repurchase or Cancellation
35-7 The amount of cash or
other assets transferred (or liabilities incurred)
to repurchase an equity award shall be charged to
equity, to the extent that the amount paid does not
exceed the fair value of the equity instruments
repurchased at the repurchase date. Any excess of
the repurchase price over the fair value of the
instruments repurchased shall be recognized as
additional compensation cost. An entity that
repurchases an award for which the promised goods
have not been delivered or the service has not been
rendered has, in effect, modified the employee’s
requisite service period or nonemployee’s vesting
period to the period for which goods have already
been delivered or service already has been rendered,
and thus the amount of compensation cost measured at
the grant date but not yet recognized shall be
recognized at the repurchase date.
To provide liquidity or for other reasons, entities may sometimes repurchase
vested common stock from their share-based payment award grantees. In some
cases, the price paid for the shares exceeds their fair value at the time of
the transaction, and the excess would generally be recognized as additional
compensation cost in accordance with ASC 718-20-35-7. In addition, an
entity’s practice of repurchasing shares, or an arrangement that permits
repurchase, could affect the classification of share-based payment awards.
See Sections
5.6 and 6.10 for additional discussion of how an entity’s past
practice affects classification.
4.12.3.2 Investor Purchases of Shares From Grantees
ASC 718-10
15-4 Share-based payments
awarded to a grantee by a related party or other
holder of an economic interest in the entity as
compensation for goods or services provided to the
reporting entity are share-based payment
transactions to be accounted for under this Topic
unless the transfer is clearly for a purpose other
than compensation for goods or services to the
reporting entity. The substance of such a
transaction is that the economic interest holder
makes a capital contribution to the reporting
entity, and that entity makes a share-based payment
to the grantee in exchange for services rendered or
goods received. An example of a situation in which
such a transfer is not compensation is a transfer to
settle an obligation of the economic interest holder
to the grantee that is unrelated to goods or
services to be used or consumed in a grantor’s own
operations.
ASC 718-10 — Glossary
Economic Interest in an Entity
Any type or form of pecuniary interest or arrangement that an entity could issue or be a party to, including
equity securities; financial instruments with characteristics of equity, liabilities, or both; long-term debt and
other debt-financing arrangements; leases; and contractual arrangements such as management contracts,
service contracts, or intellectual property licenses.
On occasion, existing investors (such as private equity or venture capital
investors) intending to increase their stake in a nonpublic entity may
undertake transactions with other shareholders in connection with or
separately from a recent financing round. Often called “secondary market
transactions,” these arrangements may include the purchase of shares of
common or preferred stock by investors from the founders of the nonpublic
entity or other individuals who are also considered employees (including
former employees). Because the transactions are between grantees of the
nonpublic entity and existing shareholders and are related to the transfer
of outstanding shares, the nonpublic entity may not be directly involved in
them (though it may be indirectly involved by facilitating the exchange or
not exercising a right of first refusal). If the price paid for the shares
exceeds their fair value at the time of the transaction, it may be difficult
to demonstrate that the transaction is not compensatory and the nonpublic
entity would most likely be required to recognize compensation cost for the
excess, even if the entity is not directly involved in the transaction. It
is important for a nonpublic entity to recognize that transactions such as
these may be subject to the guidance in ASC 718-10-15-4 because the
investors are considered holders of an economic interest in the entity.
Although the presumption in such transactions is that any consideration in
excess of the fair value of the shares is compensation paid to employees,
entities should consider whether the amount paid is related to an existing
relationship or to an obligation that is unrelated to the employees’
services to the entity in assessing whether the payment is “clearly for a
purpose other than compensation for services to the reporting entity.” Even
though it is difficult to demonstrate that a non–fair value transaction with
employees is clearly for other purposes, AIN-APB 25 (superseded by FASB Statement 123(R)) describes situations when doing so may be possible,
including those in which:
-
“[T]he relationship between the stockholder and the corporation’s employee is one which would normally result in generosity (i.e., an immediate family relationship).”
-
“[T]he stockholder has an obligation to the employee which is completely unrelated to the latter’s employment (e.g., the stockholder transfers shares to the employee because of personal business relationships in the past, unrelated to the present employment situation).”
In all situations, the determination of whether a transaction should be accounted for under ASC 718
should be based on an entity’s specific facts and circumstances.
In addition, there may be situations in which, as part of a
financing transaction between a nonpublic entity and a new investor that is
acquiring a significant ownership interest in the nonpublic entity, the new
investor purchases common shares in the nonpublic entity from employees of
the nonpublic entity. For example, the investor may not have participated in
a prior financing arrangement and may be purchasing convertible preferred
stock from the nonpublic entity and common stock from the nonpublic entity’s
existing employees. In this scenario, the investor pays the same price to
purchase the preferred stock from the nonpublic entity and the common stock
from the employees. While it did not hold an economic interest before
entering into the transaction with the nonpublic entity, the new investor is
not unlike a party that already holds such an interest and may be similarly
motivated to compensate employees.
As noted in ASC 718-10-15-4, a share-based payment arrangement between the
holder of an economic interest in a nonpublic entity and an employee of the
nonpublic entity should be accounted for under ASC 718 unless the
arrangement “is clearly for a purpose other than compensation for goods or
services.” If a new investor purchases common stock valued at an amount
based on the value of the preferred stock, we would generally expect the
analysis to be similar to that performed by a preexisting investor that
purchases common stock from a nonpublic entity’s employees.
A reporting entity’s past practice of repurchasing a
grantee’s awards in cash before the risks and rewards of share ownership are
borne by grantees (generally six months from the date on which options are
exercised or shares are vested [i.e., immature shares]) may indicate that
the awards are in-substance liabilities. However, we do not believe that a
reporting entity would generally consider a history of investor purchases of
immature shares from grantees (regardless of whether such purchases are
conducted at fair value or at an amount that exceeds fair value) when
assessing whether it has established a past practice of settling immature
shares that results in an in-substance liability (see Sections 5.6 and
6.10 for
additional discussion of how an entity’s past practice affects
classification). Generally, if the reporting entity otherwise classifies the
shares as equity, purchases of immature shares by an investor (i.e., a
related party, an existing economic interest holder, or a new investor)
cannot be used to pay off a liability on the reporting entity’s behalf.
Rather, the purchaser (often through a tender offer to grantees that is, in
part, organized by the reporting entity) is making an investment decision to
establish or increase its ownership interest in the reporting entity and
thereby is the party making a payment as the principal in the purchase
transaction with grantees. Accordingly, an investor that directly makes such
a purchase from grantees would not change the substantive terms of the
share-based payment arrangement under which the shares must be reclassified
from equity to a liability.
4.12.3.2.1 Valuation Considerations
While the examples above describe situations in which it
is likely that the nonpublic entity would recognize additional
compensation cost, we are aware of circumstances in which a secondary
market transaction between an investor and a nonpublic entity’s
employees represents an orderly arm’s-length transaction conducted at
fair value. In such cases, the nonpublic entity has adequate support for
a conclusion that the transaction was conducted at fair value and
therefore did not result in additional compensation cost. Such secondary
transactions are likely to be relevant in the nonpublic entity’s common
stock valuation, which is typically performed by a third-party valuation
firm to ensure compliance with IRC Section 409A and determine the
fair-value-based measure of the nonpublic entity’s share-based payment
arrangements (see Section 4.12.2).
When an entity does conclude that a secondary transaction includes a
compensatory element that must be recognized, there may have also been
indicators that the secondary transaction was conducted at fair value.
In such situations (i.e., there are indicators that (1) the transaction
was conducted at fair value and (2) there is a compensatory element), an
entity should consider whether to give some weight to the transaction
when determining the fair value of the common shares.
4.12.3.2.2 Tax Considerations
For tax purposes, stock repurchases are generally treated either as
capital (e.g., capital gain) or as dividend-equivalent redemptions
(e.g., ordinary dividend income to the extent that the entity has
earnings and profits). Repurchases from current or former service
providers (i.e., current or former employees or independent contractors)
give rise to questions about whether any of the proceeds should be
treated as compensation for tax purposes.
In the assessment of whether a portion of the payment is compensation, a
critical tax issue is what value is appropriate for the nonpublic entity
to use when determining the effect of the capital redemption. That is,
the nonpublic entity must determine whether some portion of the
consideration for the repurchase represents something other than fair
value for the common stock (e.g., compensation cost). When a repurchase
exceeds the fair value of the common stock, there is risk that some of
the purchase consideration is compensation for tax purposes. The
determination of whether such excess is compensatory depends on the
facts and circumstances, and there can be disparate treatment for book
and tax purposes with respect to compensation transactions as well as
ambiguity in the existing tax code. Relevant factors include whether the
repurchase is (1) performed by the nonpublic entity or an existing
investor or (2) part of arm’s-length negotiations with a new investor
that may not have the same information as the nonpublic entity about
what is considered to be the fair market value of the stock. If the
purchaser is not the nonpublic entity, it is relevant whether the shares
will be held by the buyer, or whether they can be converted into a
different class of stock or put back to the nonpublic entity. Another
factor is whether an offer to sell at a higher price is limited to
service providers or is available to shareholders more generally.
If the repurchase resulted in compensation for tax purposes, the
nonpublic entity would include such compensation on Form W-2 (for
employees) or Form 1099-MISC (for independent contractors). While any
tax liability resulting from additional compensation is the obligation
of the individual, the nonpublic entity has an obligation to (1)
withhold income and payroll taxes from payments to employees and (2)
remit the employer share of payroll tax. A nonpublic entity that does
not withhold payroll taxes from an employee in a transaction in which
the excess purchase price is compensatory becomes responsible for the
tax and should evaluate whether to accrue a liability in accordance with
the guidance in ASC 450. That guidance addresses the proper accounting
treatment of non-income-tax contingencies such as sales and use taxes,
property taxes, and payroll taxes.
An estimated loss contingency, such as a payroll tax liability, is
accrued (i.e., expensed) if (1) it is probable that the liability has
been incurred as of the date of the financial statements and (2) the
amount of the liability is reasonably estimable. A loss contingency must
be disclosed if (1) the loss is probable as of the date of the financial
statements or it is reasonably possible that the liability has been
incurred and (2) the amount is material to the financial statements.
With respect to a payroll tax liability, the liability recorded as a tax
transaction should be the best estimate of the probable amount due to
the tax authority under the applicable law, which would include interest
and penalties. In addition, the nonpublic entity would need to evaluate
whether it has any arrangements in place with its employees that would
make it responsible for its employees’ tax liability. If the best
estimate of the liability is a range, and if one amount in the range
represents a better estimate than any other amount in the range, that
amount should be recorded in accordance with ASC 450-20-30-1. If no
amount in the range is a better estimate than any other amount, the
minimum amount in the range should be used to record the liability in
accordance with ASC 450-20-30-1.
An entity has a legal right to seek reimbursement for the payroll tax
liability (although not for income tax withholding, penalties, or
interest) from employees if the IRS makes a determination to seek the
withholdings from the entity. Accordingly, an entity could record an
offsetting receivable from the employees for the payroll tax
withholdings. However, the entity will need to assess the collectability
of such a receivable, including whether the entity has sufficient
evidence of an employee’s ability to reimburse the entity for the
payroll tax liability and whether the entity has the intent to collect
this liability from the employee.
The following is an example of a disclosure that an
entity may make about its repurchase of common stock from its employees
when it has incurred a payroll tax liability as a result of not
withholding payroll taxes:
In connection with our
Series A financing, we repurchased common shares from our employees.
The transaction was undertaken to provide liquidity to our employees
and allows us to offer investors additional Series A shares without
further dilution of the existing shareholders. While we have viewed
the transaction to be a capital transaction for tax purposes, tax
authorities could challenge this characterization and consider a
portion of the payment to be compensation to the employees, which
would require us to remit payroll tax withholdings to the tax
authorities. For the probable amount of taxes and penalties that may
be payable, the Company has recorded a liability of $5 million,
which represents the low end of the range of probable amounts of
payroll tax withholdings and penalties that would be payable. The
ultimate payment amount could exceed the liability recorded, and we
estimate that the reasonably possible range of such payment could be
up to $8 million.
Given the complexities of this type of transaction, including the
evaluation of existing tax law, entities should consult with their
auditors and tax specialists when quantifying the liability under ASC
450.
Note that if a payment is considered compensation, a deduction of the
same amount would also be allowed (subject to all applicable rules
related to deductions for compensation expense).
4.12.4 Interpolation Considerations for Valuing Share-Based Compensation
Early-stage companies often obtain independent valuations once
per year. However, the dates of the valuations do not always coincide with the
grant date, or other relevant measurement date, for a share-based payment award.
As a result, management must assess the current fair value of the underlying
shares as of the measurement date.
Management should consider qualitative and quantitative factors
when assessing the current fair value of the underlying shares as of the
measurement date if a current independent valuation is not readily available. A
current independent valuation could be based on a recent arm’s-length willing
buyer, on a willing seller transaction (an “orderly transaction”9), or on value indications under the income and market approaches that are
reconciled to a value estimate. The relevance of qualitative and quantitative
factors becomes greater as the period between the most recent valuation and the
measurement date increases.
We believe that when management performs its assessment of fair
value, it should consider the factors outlined in the AICPA Valuation Guide.
However, those factors are not all-inclusive since an entity’s specific
circumstances may affect valuation. In the absence of an orderly transaction or
of the data needed for an entity to apply the income and market approaches, the
entity should work with its auditor and an independent valuation specialist to
ensure that it has properly identified all relevant factors that could affect
the fair value of the underlying share price.
When evaluating the factors in the AICPA Valuation Guide,
management should determine whether there have been any positive or negative
changes to the fair value of the underlying shares since the most recent
independent valuation. Accordingly, management may consider the following in
making its determination:
- Material changes in strategic relationships with major suppliers or customers — A loss or gain of a major supplier or customer that was not factored into the previous valuation can materially affect the entity. Changes in the financial health and profitability of strategic suppliers or customers can also affect the entity’s valuation.
- Material changes in enterprise cost structure and financial condition — A change in the cost structure flexibility (i.e., relationship between fixed and variability cost) may affect the entity’s previous expectations regarding its cash burn rate and future financial strength.
- Material changes in the management team’s competence — A change in the experience and competence of the management team may affect the entity’s future strategic objectives and direction.
- Material changes in existing proprietary technology, products, or services — The nature of the industry, patents, exclusive license arrangements, and enterprise-owned and developed intellectual property may significantly affect an entity’s valuation. Entities that do not have proprietary technology should evaluate whether there is a high likelihood of product obsolescence.
- Material changes in workforce and workforce skills — The quality of the workforce as a result of specialized knowledge or skills of key employees can be a significant input into certain entities’ valuation.
- Material change in the state of the industry and economy — Local, national, and global economic conditions may adversely or positively affect an entity.
- Material third-party arm’s-length transactions in the entity’s equity10 — These types of transactions may be indicators of fluctuation in the fair value of the underlying shares.
- Material changes in valuation assumptions used in the last valuation — The likelihood of the occurrence of a liquidity event, such as an IPO or a merger or an acquisition, or significant changes in the financial metrics or the valuations of the entity’s publicly traded comparable companies.
Entities that grant equity between two independent valuations or
after an independent valuation should consider using an interpolation or
extrapolation framework to estimate the fair value of the underlying shares.
Such frameworks may include linear interpretation, hockey stick interpolation,
or the consideration of equity granted after the most recent valuation
(extrapolation). Entities should evaluate the appropriateness of using an
interpolation framework and should consider the factors outlined above if they
use such a framework.
The examples below illustrate circumstances in which the use of
an interpolation framework may be appropriate.
Example 4-6
Linear Interpolation
Company X performed an independent
valuation of its common stock as of December 15, 20X8,
and September 18, 20X9. Company X’s common stock value
increased from $1.50 to $2.25 between December 15, 20X8,
and September 18, 20X9. On April 1, 20X9, X granted
500,000 options on its common stock to its employees,
with an exercise price of $1.50. Company X evaluated the
qualitative and quantitative factors discussed above and
did not identify any significant events that occurred
during this interim period that would have caused a
material change in fair value of the common stock.
Further, over this period, management monitored its
industry and peer group multiples and observed that
these valuation inputs did not suggest a change in the
fair value of X’s common stock.
We believe that in the absence of an
orderly transaction or data necessary for an entity to
apply the income and market approaches, it is acceptable
for management to perform a linear interpolation between
the December 15, 20X8, and September 18, 20X9, valuation
dates to determine the fair value of the common stock as
of April 1, 20X9.
After performing a linear interpolation,
X concluded that the fair value of the common stock as
of April 1, 20X9, was $1.79. When valuing the 500,000
options granted on April 1, 20X9, management would use
$1.79 as the fair value of the common stock. The graphic
below illustrates X’s linear interpolation.
Example 4-7
Hockey Stick Interpolation
Assume the same facts as in the example
above; however, Company X’s operating results were
higher than originally forecasted in the December 15,
20X8, valuation model. Specifically, X performed above
expectations during the interim period July 1, 20X9,
through September 18, 20X9. Its performance was
primarily influenced by higher than expected customer
acquisitions and improved pricing. Before July 1, 20X9,
management evaluated the qualitative and quantitative
factors discussed above and did not identify any
significant events that occurred before July 1, 20X9,
that would have caused a material change in fair value
of the common stock. Management therefore concluded that
the common stock valuation was flat during this
period.
We believe that in the absence of an
orderly transaction or of the data necessary for the
application of the income and market approaches, it is
acceptable for management to perform a “hockey stick”
interpolation between the December 15, 20X8, and
September 18, 20X9, valuation to determine the fair
value of the common stock as of April 1, 20X9. This is
because management has evidence that the increase in the
fair value of the common stock was primarily
attributable to better-than-expected growth from July 1,
20X9, through September 18, 20X9. The graphic below
illustrates X’s interpolation.
As suggested in the graphic above, X
concluded that the fair value of the common stock as of
April 1, 20X9, was $1.50. However, if management had
granted options on its common stock between July 20X9
and September 20X9, management would use the
interpolation framework above to determine the fair
value of the common stock.
Example 4-8
Equity Granted After
the Most Recent Valuation (Extrapolation)
After performing an independent
valuation of its common stock as of July 1, 20X9,
Company Y, which has a calendar year-end, concluded that
the fair value of the common stock was $2.00. On
December 1, 20X9, Y granted 500,000 options that can be
exercised on Y’s common stock. On March 1, 20X0, Y will
issue its financial statements without having an updated
independent valuation of its common stock (i.e., it will
only have the July 1, 20X9, valuation).
Company Y is generating revenue but is
currently operating at a loss. At the time of Y’s July
1, 20X9, common stock valuation, management forecasted
FYX9 revenue of $10 million and FYX0 revenue of $25
million. As of December 1, 20X9, management revaluated
its actual and forecasted revenue and concluded that
there were no material changes to its original revenue
forecast. Management considered the qualitative and
quantitative factors discussed above in determining
whether the common stock fair value had changed. On the
basis of its assessment as well as its unchanged revenue
forecast, management concluded that the common stock
fair value had remained flat and that there was no
evidence that the fair value of the common stock had
materially increased or decreased since the July 1,
20X9, valuation. As a result, when valuing the options
granted on December 1, 20X9, management used $2.00 as
the fair value of the common stock.
Assume the same facts as those above;
however, revenue for fiscal year 20X9 and forecasted
fiscal year 20X0 is 10 percent above the July 1, 20X9,
amount forecasted in the previous valuation. In this
scenario, management should develop a reasonable method
to reflect an increase in the fair value of the common
stock between July 1, 20X9, and December 1, 20X9. For
example, on the basis of Y’s July 1, 20X9, valuation,
management can approximate the incremental impact on its
common stock as a result of the revenue increase in
fiscal years 20X9 and 20X0. Using this amount as a
benchmark, management could approximate the fair value
of the common stock as of December 1, 20X9.
See Deloitte’s March 17, 2017, Financial Reporting Alert for a
discussion of disclosure considerations.
Footnotes
4
The AICPA Valuation Guide provides best-practice guidance
for valuing the equity securities of nonpublic entities. It discusses, among
other topics, possible methods of allocating enterprise value to underlying
securities, enterprise-and industry-specific attributes that should be
considered in the determination of fair value, best practices for supporting
fair value, and recommended disclosures for a registration statement.
5
Cheap stock refers to issuances of equity securities
before an IPO in which the value of the shares is below the IPO
price.
6
See footnote
4.
7
A European option can be exercised only on the
expiration date.
8
An Asian option, or average option, is an option
contract in which the payoff is based on the average price of
the stock over a specific period (as opposed to a single
point).
9
ASC 820 defines an orderly transaction as a “transaction
that assumes exposure to the market for a period before the measurement
date to allow for marketing activities that are usual and customary for
transactions involving such assets or liabilities; it is not a forced
transaction (for example, a forced liquidation or distress sale).” In
private-company financing transactions, the usual and customary
marketing activities generally include time for the investors to perform
due diligence and to discuss the company’s plans with management, the
board of directors, or both.