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”)3 emphasizes the importance of contemporaneous valuations from independent valuation specialists to determine the fair value of equity securities.

Changing Lanes

On December 21, 2025, the AICPA’s Financial Reporting Executive Committee released for public comment a working draft of its updated Accounting and Valuation Guide Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Although the guide is nonauthoritative, the revisions reflect the AICPA’s views on current best practices for estimating the fair value of equity securities underlying share-based payment arrangements.

The working draft includes proposed updates to sections addressing the valuation of equity securities in complex capital structures, primary and secondary market transactions, and related accounting and disclosure matters. The purpose of the updates is to align the guide more closely with existing accounting standards, including ASC 820 and ASC 718.

The proposed revisions may affect how private companies evaluate and support fair value estimates for equity securities underlying share-based payment arrangements. Private companies and other stakeholders involved in valuations for financial reporting purposes should consult the draft guidance when considering future transactions and valuation analyses.

For more information about the working draft, see Deloitte’s March 28, 2025, Technology Spotlight.

4.12.1 Cheap Stock

The SEC often focuses on “cheap stock”4 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 Guide5 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 European6 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 Asian7 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 Section 5.6 and Section 6.10 for additional discussion of how an entity’s past practice affects classification.

When an entity repurchases shares, it should first determine whether the shares being repurchased were originally issued as a share-based payment award within the scope of ASC 718. If so, the entity generally applies ASC 718 to assess whether the repurchase price includes a compensatory element (e.g., consideration paid in excess of fair value). In certain circumstances, the entity may need to use judgment to evaluate whether the former employee is being treated primarily as a shareholder (e.g., in a pro rata broad-based tender offer to the entire shareholder population) or as a service provider (i.e., in a targeted repurchase based on past services). In addition, if an entity repurchases shares from employees that were not originally issued as compensation (i.e., employee founders' shares), we believe that the entity should apply the repurchase guidance in ASC 718 when evaluating whether the transaction includes a compensatory element.

Further, when a related party or other economic interest holder purchases shares from employees, former employees, or founders, the transaction is generally presumed to be on behalf of the entity, and any amount paid in excess of fair value is treated as compensation, with a corresponding capital contribution. See discussion in the next section.

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 Section 5.6 and Section 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.

Example 4-6

Investor P recently acquired preferred stock from Entity A and is seeking to increase its equity ownership of A. To facilitate this increase without a new primary issuance for cash and without requiring other investors to sell their interests, A identifies executive employees that collectively hold 1,000 shares of A’s common stock that they previously received under the terms of a share-based payment arrangement.

Investor P agrees to purchase the executive employees’ common shares for $10 per share, which is the same price P recently paid A to acquire the preferred shares it currently owns. The fair value of the common shares is $5 per share, which is based on a contemporaneous valuation performed at the time of P’s purchase and broadly in line with other secondary common share transactions that took place in reasonable proximity to P’s purchase. Management concludes that market participants place significant value on the liquidation preference and other rights and preferences embedded in the preferred stock and that no such liquidation preference (or similar right) is present in the common stock held by the executive employees. Accordingly, the $10 purchase price exceeds the current fair value of the common shares ($5 per share) because it reflects consideration of value ascribed to rights (e.g., liquidation preferences) that are not present in the common shares.

Entity A facilitates the transactions between P and each employee by (1) waiving its right of first refusal related to each employee’s sale of common stock and (2) simultaneously effecting an exchange so that the common shares purchased by P are converted into preferred shares on a one-for-one basis. To effectuate the exchange into preferred shares, A reacquires and retires the common shares obtained by P and contemporaneously issues to P an equal number of preferred shares of the same series and with the same terms as the preferred shares P recently purchased.

Entity A evaluates whether the arrangement contains a compensatory element by considering the indicators discussed in Chapters 8 and 9 of the AICPA Valuation Guide. On the basis of those indicators, A concludes that the transaction does contain a compensatory element because (1) the price paid for the employees’ common shares exceeds their fair value and is not attributable to rights embedded in the common shares and (2) A’s involvement is substantive (e.g., it identified key executive employees with sufficient common-share holdings, waived its right of first refusal, and effected the contemporaneous reacquisition/retirement of common shares and issuance of preferred shares to Investor P).8

In substance, P paid A $10 per share for the preferred shares that A issued to P. Entity A then used the $10 per share received from P to repurchase from employees common shares whose fair value was $5 per share. The excess of the repurchase price over the fair value of the common shares represents compensation cost (i.e., $10 − $5 = $5 per share, or $5,000 in total for 1,000 shares) in accordance with ASC 718-10-15-4. Entity A also accounts for the reacquisition and retirement of the common shares and the contemporaneous issuance of preferred shares9, 10 to P in a manner consistent with the equity transaction necessary to effect the exchange.

Note that in this example, A can confirm that the price of the common shares as a result of the valuation, which was performed at the same time as P’s purchase of common shares, was generally consistent with the price observed in other recently conducted secondary transactions. On the other hand, the occurrence of secondary transactions of common shares in the principal market that were more consistent with P’s entry price for the preferred financing (i.e., $10 per share) would indicate that market participants value the company on a common-stock-equivalent basis and do not place significant value on the liquidation preferences and other features of the preferred shares, in which case A may view the $10 price as an observable secondary transaction without a compensatory element.

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”11), 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 equity12 — 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 4-7

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 4-8

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 4-9

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

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.

Cheap stock refers to issuances of equity securities before an IPO in which the value of the shares is below the IPO price.

See footnote 3.

A European option can be exercised only on the expiration date.

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).

For more information about the accounting for treasury stock transactions, see Section 10.4.4 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.

We believe that it would be inappropriate to assess the transaction with P as an issuance of common stock followed by a contemporaneous modification into preferred stock. That is, A should not apply the modification or extinguishment guidance on preferred instruments to this transaction. The issuance and modification occurred contemporaneously and in contemplation of one another. Accordingly, A should account for the transaction as (1) a repurchase and extinguishment of common shares and (2) an issuance of preferred stock to P at fair value.

Alternatively, if the fair value of the preferred shares was greater than the amount paid by P (e.g., the preferred shares had a fair value of $12 per share), A should consider whether to recognize the excess of fair value over the amount paid as a dividend or an expense. See Section 10.3.2 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.

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.

For additional information about considering secondary transactions, see Chapter 8 of the AICPA Valuation Guide.

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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.