On the Radar

Nonpublic limited partnerships, limited liability companies, and other pass-through entities often establish special classes of equity, referred to as profits interests. These special equity classes often have distribution thresholds or hurdles related to amounts that must be paid to other classes of equity before the grantee of the profits interest can receive distributions. On the grant date, an award may have zero liquidation value for tax purposes but a fair value for financial reporting purposes.

While the features of a profits interest award can vary, such an award should be accounted for on the basis of its substance. If the award has the characteristics of an equity interest, it represents a “substantive class of equity” and should be accounted for under ASC 718. However, an award that is, in substance, a performance bonus or a profit-sharing arrangement would be accounted for as such in accordance with other U.S. GAAP (e.g., typically ASC 710 for employee arrangements).

There are several characteristics to consider when determining whether an instrument is within the scope of ASC 718. To be a substantive class of equity, the profits interest must be legal form equity. An entity would also consider whether the instrument’s holder can retain a vested interest in an award if the holder stops providing goods or services to the company. In determining whether a repurchase feature allows the grantee to retain a vested interest, an entity would assess whether the repurchase price of that repurchase feature is consistent with the fair value of the award. Other characteristics of the award (e.g., claim to residual assets of the entity upon liquidation, substantive net assets underlying the interest, and distribution rights after vesting) could also be relevant to the entity’s conclusion.

Some of these questions typically only pertain to nonpublic entities. For example, nonpublic entities often include repurchase features to remain closely held or may choose to settle the award in cash to provide liquidity to the grantee for shares that are not actively traded.

A nonpublic company should carefully evaluate secondary transactions when determining the fair value of its common shares. Often, an entity may conclude that a secondary transaction includes a compensatory element that must be recognized even when there are also indicators that the secondary transaction was conducted at fair value. In such situations, an entity should consider whether to give some weight to that transaction when determining the fair value of the common shares.

When the estimated fair value of an entity’s stock is significantly below the anticipated IPO price, the entity should be able to reconcile the change in the estimated fair value of the underlying equity between the award grant date and the IPO. To perform this reconciliation, the entity would take into account, among other things, intervening events and changes in assumptions that justify 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 value measurements with the anticipated IPO price (including significant intervening events); (2) describe its valuation methods; (3) justify its significant valuation assumptions, including (a) the weight given to operating the business both under and in the absence of an IPO and (b) the appropriateness of the entity’s comparable companies under the market approach; and (4) discuss the weight it gives to secondary transactions (see discussion above).