4.8 Restricted Shares

ASC 718-10 — Glossary

Restricted Share

A share for which sale is contractually or governmentally prohibited for a specified period of time. Most grants of shares to grantees are better termed nonvested shares because the limitation on sale stems solely from the forfeitability of the shares before grantees have satisfied the service, performance, or other condition(s) necessary to earn the rights to the shares. Restricted shares issued for consideration other than for goods or services, on the other hand, are fully paid for immediately. For those shares, there is no period analogous to an employee’s requisite service period or a nonemployee’s vesting period during which the issuer is unilaterally obligated to issue shares when the purchaser pays for those shares, but the purchaser is not obligated to buy the shares. The term restricted shares refers only to fully vested and outstanding shares whose sale is contractually or governmentally prohibited for a specified period of time. Vested equity instruments that are transferable to a grantee’s immediate family members or to a trust that benefits only those family members are restricted if the transferred instruments retain the same prohibition on sale to third parties. See Nonvested Shares.

ASC 718-10

Vesting Versus Nontransferability

30-10 To satisfy the measurement objective in paragraph 718-10-30-6, the restrictions and conditions inherent in equity instruments awarded are treated differently depending on whether they continue in effect after the requisite service period or the nonemployee’s vesting period. A restriction that continues in effect after an entity has issued awards, such as the inability to transfer vested equity share options to third parties or the inability to sell vested shares for a period of time, is considered in estimating the fair value of the instruments at the grant date. For equity share options and similar instruments, the effect of nontransferability (and nonhedgeability, which has a similar effect) is taken into account by reflecting the effects of grantees’ expected exercise and postvesting termination behavior in estimating fair value (referred to as an option’s expected term).

30-10A On an award-by-award basis, an entity may elect to use the contractual term as the expected term when estimating the fair value of a nonemployee award to satisfy the measurement objective in paragraph 718-10-30-6. Otherwise, an entity shall apply the guidance in this Topic in estimating the expected term of a nonemployee award, which may result in a term less than the contractual term of the award.

30-10B When a nonpublic entity chooses to measure a nonemployee share-based payment award by estimating its expected term and applies the practical expedient in paragraph 718-10-30-20A, it must apply the practical expedient to all nonemployee awards that meet the conditions in paragraph 718-10-30-20B. However, a nonpublic entity may still elect, on an award-by-award basis, to use the contractual term as the expected term as described in paragraph 718-10-30-10A.

Nonvested or Restricted Shares

30-18 Nonvested shares granted in share-based payment transactions usually are referred to as restricted shares, but this Topic reserves that term for fully vested and outstanding shares whose sale is contractually or governmentally prohibited for a specified period of time.

30-19 A restricted share awarded to a grantee, that is, a share that will be restricted after the grantee has a vested right to it, shall be measured at its fair value, which is the same amount for which a similarly restricted share would be issued to third parties. Example 8 (see paragraph 718-20-55-71) provides an illustration of accounting for an award of nonvested shares to employees.

Fair Value Measurement Objectives and Application

55-5 A restriction that continues in effect after the entity has issued instruments to grantees, such as the inability to transfer vested equity share options to third parties or the inability to sell vested shares for a period of time, is considered in estimating the fair value of the instruments at the grant date. For instance, if shares are traded in an active market, postvesting restrictions may have little, if any, effect on the amount at which the shares being valued would be exchanged. For share options and similar instruments, the effect of nontransferability (and nonhedgeability, which has a similar effect) is taken into account by reflecting the effects of grantees’ expected exercise and postvesting termination behavior in estimating fair value (referred to as an option’s expected term).

A restricted share is a fully vested and outstanding share whose sale is prohibited for a specified period. For example, as described in Section 3.3, a grantee may be granted a fully vested share but may be restricted from selling it for a two-year period. If the grantee ceases delivering goods or rendering services to the entity before the end of the two-year period, the grantee retains the share. However, the grantee’s ability to sell the share remains contingent on the lapse of the two-year period. When determining a share-based payment award’s fair-value-based measure, an entity should generally consider restrictions that are in effect after a grantee has vested in the award, such as the inability to transfer or sell vested shares for a specified period, including any discounts relative to the fair value of the shares without a postvesting restriction. This discount is often referred to as a discount for lack of marketability (DLOM) or discount for illiquidity.

Entities must be able to provide objective and verifiable evidence supporting the amount of the discount. In determining an appropriate discount, entities should consider the following remarks by Barry Kanczuker, then associate chief accountant in the SEC’s Office of the Chief Accountant, at the 2015 AICPA Conference on Current SEC and PCAOB Developments:

I would now like to turn to an observation regarding the impact of post-vesting restrictions on the measurement of share-based awards. The measurement of share-based awards impacts compensation expense. Post-vesting restrictions, such as transfer or sale restrictions, are a common feature of many share-based payment arrangements.

ASC 718 provides guidance on the accounting for share-based awards when the sale of the underlying shares is prohibited for a period of time subsequent to the awards vesting date. The post-vesting restrictions should be considered when estimating the grant-date fair value of the award [ASC 718-10-30-10]. I would expect that a post-vesting restriction may result in a discount relative to the market value of common stock to reflect that the market shares can be freely traded while restricted shares cannot. The assumptions used in determining the value of the share-based award should be attributes that a market participant would consider related to the underlying award, rather than an attribute related to the individual holding the award.

Some market participants have indicated that post-vesting holding restrictions on share-based payment awards can result in significantly lower stock compensation expense. While post-vesting restrictions should be considered in estimating the fair value of share-based payments [ASC 718-10-30-10], when evaluating the appropriateness of measurement in this area, we continue to look to the guidance in ASC 718-10-55-5, which states that “. . . if shares are traded in an active market, post-vesting restrictions may have little, if any, effect on the amount at which the shares being valued would be exchanged”. With that being said, I would encourage you to consult with the Staff if you believe that you have a fact pattern in which a post-vesting restriction results in a significant discount being applied to the grant-date fair value of a share-based award. [Footnotes omitted]

In addition, entities should consider remarks by Sandie Kim, then professional accounting fellow in the SEC’s Office of the Chief Accountant, at the 2007 AICPA Conference on Current SEC and PCAOB Developments:

Statement 123(R) establishes fair value as the measurement objective in accounting for share-based payment arrangements. While the actual measurement of share-based payment arrangements is not necessarily at fair value and Statement 157 does not apply to such arrangements, Statement 123(R) nonetheless states that the valuation and assumptions used should be consistent with the fair value measurement objective.

One analysis that may sometimes be difficult in valuing any security, not just those issued in share-based payment arrangements, is determining which assumptions should be incorporated in the valuation because they are attributes a market participant would consider (it is an attribute of the security), versus an attribute a specific holder of the security would consider. For example, one common term we see in share-based payment arrangements is a restriction that prohibits the transfer or sale of securities. If the security contains such a restriction that continues after the requisite service period, that post-vesting restriction may be factored as a reduction in the value of the security. As a reminder, the staff has previously communicated that the discount calculated should be specific to the security, and not derived based on general rules of thumb.

On the other hand, we have also seen instances in which assumptions related to a specific holder attribute were incorporated in the valuation of share-based payments. While the determination of which assumptions to incorporate is judgmental, we believe that it would be difficult to substantiate that assumptions that reflect an attribute of a specific holder versus a market participant would be appropriate. Statement 123(R) specifies that the assumptions should reflect information available to form the basis for an amount at which the instrument being valued would be exchanged, and that the assumptions used should not represent the biases of a particular party. For example, we have heard arguments that a significant discount should be taken on certain share-based payment awards because the securities were issued to a group of executives that were subject to higher taxes than other employees. The staff does not believe this assumption is consistent with a fair value measurement objective. As an additional observation, Statement 157 also refers to assumptions that are incorporated in the fair value of a security because they are specific to the security (that is, attributes of the security) and would, therefore, transfer to market participants. [Footnotes omitted]

There are several valuation techniques used to determine a DLOM, as further described in Section 4.12.1.

4.8.1 Options on Restricted Shares

If an entity grants options to acquire restricted shares (as defined in ASC 718), it should take into account the effect of the postvesting restriction by using the restricted share value as an input in the option pricing model. That is, the discount for the postvesting restriction should not be applied to the output of the option pricing model.

For example, assume that a public entity issues an option with a four-year service (vesting) condition and a postvesting restriction that prohibits the grantee from selling the shares obtained upon exercising the option for another two years. If the entity estimates the fair-value-based measure of the option by using a Black-Scholes-Merton formula, the input used for the current market price of the underlying share generally will not be the quoted market price of the entity’s common stock since the underlying share contains a postvesting restriction. Rather, the entity should generally use the fair value of a similar restricted share as the input for the current market price (i.e., the fair value of a share containing similar restrictions on transferability for a period of two years). The fair value of a restricted share typically should be lower than the fair value of a similar share without any restrictions. Therefore, using the fair value of a restricted share in the Black-Scholes-Merton formula will result in an estimated fair-value-based measure of the option that is lower than that of an option without any postvesting restrictions on the underlying share (if all other inputs remain the same).

A restriction on the ability to sell or transfer the option itself is different from a restriction on the underlying share. If the option (as opposed to the underlying share) is nontransferable, which is typically the case for employee stock options, the expected-term assumption is adjusted to reflect the restriction rather than the input associated with the current market price of the underlying share. This restriction generally leads to the early exercise of the option (before the end of the contractual term), and since a discount is factored into the expected-term assumption, no additional discount should be applied to the estimated fair-value-based measure derived from the option-pricing model. See Section 4.9.2.2.

4.8.2 Limited Population of Transferees

In certain cases, the terms of a share-based payment arrangement may permit the transfer of shares only to a limited population, such as in an offering under Rule 144A of the Securities Act of 1933. A limited population of transferees is not a prohibition on the sale of the instrument and therefore is not considered a restriction under ASC 718. As described in Section 4.7, the fair-value-based measure of restricted stock (i.e., nonvested shares) is calculated at the fair value of the entity’s common stock as if the restricted stock were vested and issued on the grant date. An entity should not discount that value solely because the entity’s common stock could be transferred to only a limited population of transferees.

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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.