5.8 Share-Based Compensation

An entity that is preparing for an IPO may have a share-based compensation strategy designed to retain and attract employees and nonemployees. Share-based compensation often is in the form of stock options, stock appreciation rights, restricted stock, restricted stock units, or an employee stock purchase plan (ESPP). In addition, an entity may use share-based compensation to purchase goods or services from third-party vendors or service providers. Management should consider the financial reporting implications associated with each of the various types of share-based compensation arrangements that an entity may enter into with employees and nonemployees. Additional topics that an entity undergoing an IPO often must consider include the valuation of share-based compensation, repurchase features, certain profit-sharing arrangements, performance conditions associated with liquidity events, modifications, employee loans, escrowed stock arrangements, EPS, and disclosures.

This section of the Roadmap focuses on share-based compensation granted to grantees under ASC 718. In this section, it is assumed that an entity has adopted ASU 2018-07, which simplifies the accounting for share-based payments granted to nonemployees for goods and services. While ASU 2018-07 aligns most of the guidance on nonemployee share-based payment awards with the requirements for employee share-based payment awards, certain differences remain. Because of these differences, it is still important for an entity to consider whether the counterparty in an arrangement is an employee or a nonemployee when accounting for share-based payment awards. See Chapter 9 of Deloitte’s Roadmap Share-Based Payment Awards for a discussion of awards granted to nonemployees.

As a reminder, share-based payment awards accounted for under ASC 718 must be either (1) settled by issuing the entity’s equity shares or other equity instruments or (2) indexed, at least in part, to the value of the entity’s equity shares or other equity instruments. Generally, equity-classified share-based payment awards are measured by using a fair-value-based measure on their grant date. Liability-classified share-based payment awards are also generally measured by using a fair-value-based measurement; however, they are remeasured in each subsequent reporting period until settlement. The fair-value-based measure for share-based payment awards is recognized over the requisite service period, which often is the vesting period.

5.8.1 Valuation

One of the most significant inputs related to measuring share-based compensation is the underlying valuation of the entity’s shares. A pre-IPO entity should become familiar with the U.S. GAAP and SEC valuation requirements, including differences between valuation methods for public entities and those for nonpublic entities. The sections below summarize some of the more significant considerations related to share-based compensation for an entity contemplating an IPO.

5.8.1.1 Pre-IPO Valuation Considerations

ASC 718-10

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 nonpublic entities to measure share-based payment awards (the terms below are defined in the ASC master glossary):

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.”
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.

Changing Lanes

In October 2021, the FASB issued ASU 2021-07, which allows nonpublic entities to use, as a practical expedient, “the reasonable application of a reasonable valuation method” to determine the current price input of equity-classified share-based payment awards issued to both employees and nonemployees on a measurement-date-by-measurement-date basis. The ASU notes that a valuation performed in accordance with specified U.S. Treasury regulations related to Section 409A of the Internal Revenue Code (IRC) is an example of a reasonable valuation method under the practical expedient. The ASU also explicitly refers to other valuation approaches under IRC Section 409A that are presumed to be reasonable. The guidance in ASU 2021-07 is effective for nonpublic entities for fiscal years beginning on or after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Entities must apply the ASU’s provisions prospectively and may early adopt them for interim and annual financial statements that have not yet been issued or made available for issuance as of October 25, 2021.

As discussed in Sections 5.8.1.1.2 and 5.8.1.1.3, under ASC 718, nonpublic entities can apply other practical expedients related to the use of the calculated value and intrinsic value. In SAB Topic 14.B, the SEC provides transition guidance for entities that elect those practical expedients and are changing their status from nonpublic entity to public entity (see Section 5.8.1.2.2). However, there is no similar transition guidance in ASU 2021-07 on the use of the practical expedient. Therefore, an entity that no longer meets the criteria to be a nonpublic entity would have to reverse the practical expedient’s effect in its historical financial statements. Consequently, before electing the practical expedient in ASU 2021-07, nonpublic entities that could become public entities should carefully consider the potential future costs of having to perform such a reversal.

5.8.1.1.1 Fair-Value-Based Measurement

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 Accounting and Valuation Guide on valuation of privately-held-company equity securities issued as compensation (the “AICPA Valuation Guide”) emphasizes the importance of using contemporaneous valuations from independent valuation specialists to determine the fair value of equity securities.

5.8.1.1.2 Calculated Value

When stock options or similar instruments are granted by a nonpublic entity, the entity should try to use a fair-value-based measure to value those equity-classified awards. However, in certain instances, a nonpublic entity may not be able to reasonably estimate the fair-value-based measure of its options and similar instruments because it is not practicable for it to estimate the expected volatility of its share price. In these cases, the nonpublic entity should substitute the historical volatility of an appropriate industry sector index for the expected volatility of its own share price. In assessing whether it is practicable to estimate the expected volatility of its own share price, the entity should consider the following factors:

Whether the entity has an internal market for its shares (e.g., investors or employees can purchase and sell shares).
Previous issuances of equity in a private transaction or convertible debt provide indications of the historical or implied volatility of the entity’s share price.
Whether there are similarly sized public entities (including those within an index) in the same industry whose historical or implied volatilities could be used as a substitute for the nonpublic entity’s expected volatility.

If, after considering the relevant factors, the nonpublic entity determines that estimating the expected volatility of its own share price is not practicable, it should use the historical volatility of an appropriate industry sector index as a substitute in estimating the fair-value-based measure of its awards.

An appropriate industry sector index would be one that is narrow enough to reflect the nonpublic entity’s nature and size (if possible). For example, the use of the Philadelphia Exchange (PHLX) Semiconductor Sector Index is not an appropriate industry sector index for a small nonpublic software development entity because it represents neither the industry in which the nonpublic entity operates nor the size of the entity. The volatility of an index of smaller software entities would be a more appropriate substitute for the entity’s expected volatility of its own share price.

Under ASC 718-10-55-58, an entity that uses an industry sector index to determine the expected volatility of its own share price must use the index’s historical volatility (rather than its implied volatility). However, ASC 718-10-55-56 states that “in no circumstances shall a nonpublic entity use a broad-based market index like the S&P 500, Russell 3000, or Dow Jones Wilshire 5000” (emphasis added).

A nonpublic entity’s conclusion that estimating the expected volatility of its own share price is not practicable may be subject to scrutiny. We would typically expect a nonpublic entity that can identify an appropriate industry sector index would be able to identify similar entities from the selected index to estimate the expected volatility of its own share price and would therefore be required to use the fair-value-based measurement method.

In measuring awards, a nonpublic entity should switch from using a calculated value to using a fair-value-based measure when it (1) can subsequently estimate the expected volatility of its own share price or (2) becomes a public entity. ASC 718-10-55-27 states that the “valuation technique an entity selects [should] be used consistently and [should] not be changed unless a different valuation technique is expected to produce a better estimate” of a fair-value-based measure (or, in this case, a change to a fair-value-based measure). The guidance goes on to state that a change in valuation technique should be accounted for as a change in accounting estimate under ASC 250 and should be applied prospectively to new awards.6 Therefore, for existing equity-classified awards (i.e., unvested equity awards that were granted before an entity switched from the calculated value method to a fair-value-based measure), an entity would continue to recognize compensation cost on the basis of the calculated value determined as of the grant date unless the award is subsequently modified. An entity should use the fair-value-based method to measure all awards granted after it switches from the calculated value method.

ASC 718-20-55-76 through 55-83 provide an example of when it may be appropriate for a nonpublic entity to use the calculated value method.

5.8.1.1.3 Intrinsic Value

Nonpublic entities can make a policy election to measure all liability-classified awards (not including awards determined to be consideration payable to a customer) at intrinsic value (instead of at their fair-value-based measure or calculated value) as of the end of each reporting period until the award is settled. However, it is preferable for an entity to use the fair-value-based method to justify a change in accounting principle under ASC 250. Therefore, a nonpublic entity that has elected to measure its liability-classified awards at a fair-value-based measure (or calculated value) would not be permitted to subsequently change to the intrinsic-value method.

ASC 718-30-55-12 through 55-20 illustrate the application of the intrinsic value method for liability-classified awards granted by a nonpublic entity.

5.8.1.1.4 Cheap Stock

The SEC often focuses on “cheap stock”7 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 and 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 FRM, which outlines considerations registrants should take into account 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, (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 Guide and to consult with their valuation specialists. Further, such entities 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. For further discussion of disclosures related to cheap stock, see Section 5.8.4.1.

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 discount for lack of marketability (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 in which the stock is illiquid.

In addition to considerations related to cheap stock, entities commonly face issues caused by obtaining independent valuations infrequently, because the dates of those valuations do not always coincide with the grant dates for share-based payment awards. As a result, management will need to assess the current fair value of the underlying shares as of the grant date. Further, an entity could evaluate the use of an interpolation or extrapolation framework to estimate the fair value of the underlying shares when equity is granted (1) on dates between two independent valuations or (2) after the date of an independent valuation. For details on interpolation and extrapolation methods, including examples, see Chapter 4.12.4 of Deloitte’s Roadmap Share-Based Payment Awards.

5.8.1.1.5 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. IRC Section 409A 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 issuing 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 to 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 their shares 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. 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 IRC Section 409A assessments to value 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.

5.8.1.1.6 Purchase of Shares From Grantees

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.

On occasion, existing investors (such as private equity or venture capital investors) intending to increase their stake in an emerging nonpublic entity may undertake transactions with other shareholders in connection with or separately from a recent financing round. These transactions 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. 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 such a transaction may be subject to the guidance in ASC 718 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, under ASC 718, an entity 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 goods or services to the reporting entity.” Although 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 in which doing so may be possible, including the following:

“[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.

Shares purchased from grantees by a related party or an economic interest holder may include shares that have been vested (or have been issued as a result of the exercise of options) for less than six months (i.e., the shares are considered immature). 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 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 a substantive liability. Generally, if the reporting entity otherwise classifies the shares as equity, purchases of such shares by the related party or economic interest holder do not satisfy 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 therefore is the party making a payment as the principal in the purchase transaction with grantees. Accordingly, a related party or an economic interest holder that directly makes such a purchase from grantees would not change the substantive terms of the share-based payment arrangement that requires the reclassification of the shares from equity to a liability.

See Sections 5.6 and 6.10 of Deloitte’s Roadmap Share-Based Payment Awards for additional discussion of how an entity’s past practice affects the classification of share-based payment awards.

5.8.1.2 Valuation Considerations for Public Entities

5.8.1.2.1 SAB Topic 14, “Share-Based Payment”

The SEC issued SAB Topic 14 (codified in ASC 718-10-S99-1) to “assist issuers in their application of FASB ASC Topic 718 and enhance the information received by investors and other users of financial statements.” SAB Topic 14 contains interpretive guidance related to share-based payment transactions (e.g., guidance on the transition from nonpublic-entity to public-entity status and valuation methods, including assumptions such as expected volatility and expected term).

In November 2021, the SEC staff issued Staff Accounting Bulletin (SAB) No. 120, which provides the SEC staff’s views on the measurement and disclosure of certain share-based payment awards granted when entities possess material nonpublic information (i.e., “spring-loaded” awards). In SAB 120, the SEC staff describes a spring-loaded award as follows:

A share-based payment award granted when a company is in possession of material nonpublic information to which the market is likely to react positively when the information is announced is sometimes referred to as being “spring-loaded.”

Under the SAB, an entity that grants a share-based payment award while in possession of positive material nonpublic information should consider whether adjustments to the following are appropriate when determining the fair-value-based measure of the award: (1) the current price of the underlying share or (2) the expected volatility of the price of the underlying share for the expected term of the share-based payment award.

5.8.1.2.2 Transition From Nonpublic-Entity to Public-Entity Status

The measurement alternatives available to a nonpublic entity (calculated value and intrinsic value) are no longer appropriate once the entity is considered a public entity.8 In addition, the practical expedient related to determining the expected term of certain options and similar instruments is used differently by public entities than it is by nonpublic entities. To estimate the expected term as a midpoint between the requisite service period and the contractual term of an award, entities will need to comply with the requirements of the SEC’s simplified method. The simplified method is described in further detail in Section 5.8.1.2.3.1.

In SAB Topic 14.B, the SEC discusses various transition issues associated with valuing share-based payment awards related to an entity’s becoming public (e.g., when the entity files its initial registration statement with the SEC), including the following:

If a nonpublic entity historically measured equity-classified share-based payment awards at their calculated value, the new public entity should continue to use that approach for share-based payment awards granted before the date it becomes a public entity unless those awards are subsequently modified, repurchased, or canceled.
If a nonpublic entity historically measured liability-classified share-based payment awards on the basis of their intrinsic value and the awards are still outstanding, the new public entity should measure those liability awards at a fair-value-based measurement upon becoming a public entity.
Upon becoming a public entity, the entity is prohibited from retrospectively applying the fair-value-based measurement to its awards if it used calculated value or intrinsic value before the date it became a public entity.
Upon becoming a public entity, the entity should clearly describe in its MD&A the change in accounting policy that will be required by ASC 718 in subsequent periods and any reasonably likely material future effects of the change.

The SEC’s guidance does not address how an entity should account for a change from the intrinsic value method for measuring liability-classified awards to the fair-value-based method. In informal discussions, the SEC staff indicated that it would be acceptable to record the effect of such a change as compensation cost in the current period or to record it as the cumulative effect of a change in accounting principle in accordance with ASC 250. While the preferred approach is to treat the effect of the change as a change in accounting principle under ASC 250, with the cumulative effect of the change recorded accordingly, recording it as compensation cost is not objectionable given the SEC’s position. Under either approach, entities’ financial statements should include the appropriate disclosures.

ASC 250-10-45-5 states that an “entity shall report a change in accounting principle through retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so.” Retrospective application of the effects of a change from intrinsic value to fair value would be impracticable because objectively determining the assumptions an entity would have used for the prior periods would be difficult without the use of hindsight. Therefore, the change would be recorded as a cumulative-effect adjustment to retained earnings and applied prospectively, as discussed in ASC 250-10-45-6 and 45-7. This conclusion is consistent with the guidance in SAB Topic 14.B that states that entities changing from nonpublic to public status are not permitted to apply the fair-value-based method retrospectively.

5.8.1.2.3 Valuation Assumptions

The sections below discuss three significant share-based compensation valuation assumptions addressed in SAB Topic 14.D, including those related to expected, expected volatility, and the current price of the underlying share.

5.8.1.2.3.1 Expected Term

ASC 718-10-55-30 states, in part:

The expected term of an employee share option or similar instrument is the period of time for which the instrument is expected to be outstanding (that is, the period of time from the service inception date to the date of expected exercise or other expected settlement).

Although ASC 718 does not specify a method for estimating the expected term of an award, such a method must be objectively supportable. Similarly, historical observations should be accompanied by information about why future observations are not expected to change, and any adjustments to these observations should be supported by objective data. ASC 718-10-55-31 identifies the following factors an entity may consider in estimating the expected term of an award:

The vesting period of the award — Options generally cannot be exercised before vesting; thus, an option’s expected term cannot be less than its vesting period.
Historical exercise and postvesting employment termination behavior for similar grants — Historical experience should be an entity’s starting point for determining expectations of future exercise and postvesting termination behavior. Historical exercise patterns should be modified when current information suggests that future behavior will differ from past behavior. For example, rapid increases in an entity’s stock price after the release of a new product in the past could have caused more grantees to exercise their options as soon as the options vested. If a similar increase in the entity’s stock price is not expected, the entity should consider whether adjusting the historical exercise patterns is appropriate.
Expected volatility of the underlying share price — An increase in the volatility of the underlying share price tends to result in an increase in exercise activity because more grantees take advantage of increases in an entity’s share price to realize potential gains on the exercise of the option and subsequent sale of the underlying shares. ASC 718-10-55-31(c) states, “An entity also might consider whether the evolution of the share price affects [a grantee’s] exercise behavior (for example, [a grantee] may be more likely to exercise a share option shortly after it becomes in-the-money if the option had been out-of-the-money for a long period of time).” The exercise behavior based on the evolution of an entity’s share price can be more easily incorporated into a lattice model than into a closed-form model.
Blackout periods — A blackout period is a period during which exercise of an option is contractually or legally prohibited. Blackout periods and other arrangements that affect the exercise behavior associated with options can be included in a lattice model. Unlike a closed-form model, a lattice model can be used to calculate the expected term of an option by taking into account restrictions on exercises and other postvesting exercise behavior.
Employees’ ages, lengths of service, and home jurisdictions — Historical exercise information could have been affected by the profile of the employee group. For example, during a bull market, some entities are more likely to have greater turnover of employees since more opportunities are available. Many such employees will exercise their options as early as possible. These historical exercise patterns should be adjusted if similar turnover rates are not expected to recur in the future.

If historical exercise and postvesting employment termination behavior are not readily available or do not provide a reasonable basis on which to estimate the expected term, alternative sources of information may be used. For example, an entity may use a lattice model to estimate the expected term (the expected term is not an input in the lattice model but rather is inferred on the basis of the output of the lattice model). In addition, an entity may consider using other relevant and supportable information such as industry averages or published academic research. When an entity takes external peer group information into account, there should be evidence that such information has been sourced from entities with comparable facts and circumstances. Further, entities may use practical expedients to estimate the expected term for certain awards. Question 6 of SAB Topic 14.D.2 notes that if a public entity concludes that “its historical share option exercise experience does not provide a reasonable basis upon which to estimate expected term,” the entity may use what the SEC staff describes as a “simplified method” to develop the expected-term estimate. Under the simplified method, the public entity uses an average of the vesting term and the original contractual term of an award. The method applies only to awards that qualify as “plain-vanilla” options.

As discussed above, an entity measures stock options under ASC 718 by using an expected term that takes into account the effects of grantees’ expected exercise and postvesting behavior. However, determining an expected term for nonemployee awards could be challenging because entities may not have sufficient historical data related to the early exercise behavior of nonemployees, particularly if nonemployee awards are not frequently granted. In addition, nonemployee stock option awards may not be exercised before the end of the contractual term if they do not contain certain features typically found in employee stock option awards (e.g., nontransferability, nonhedgeability, and truncation of the contractual term because of postvesting service termination). Accordingly, ASC 718 allows an entity to elect on an award-by-award basis to use the contractual term as the expected term for nonemployee awards. If an entity elects not to use the contractual term for a particular award, the entity must estimate the expected term. However, a nonpublic entity can make an accounting policy election to apply a practical expedient to estimate the expected term for awards that meet the conditions in ASC 718-10-30-20B (see discussion in Section 9.4.2.1 of Deloitte’s Roadmap Share-Based Payment Awards). In accordance with ASC 718-10-55-29A, if an entity does not elect to use the contractual term as the expected term for a particular award and, for a nonpublic entity, does not apply the practical expedient to estimate the expected term, the entity should consider factors similar to those in ASC 718-10-55-29 when estimating the expected term for nonemployee awards.

As the SEC states in SAB Topic 14.D.2, the simplified method applies only to awards that qualify as plain-vanilla options. A share-based payment award must possess all of the following characteristics to qualify as a plain-vanilla option:

“The share options are granted at-the-money.”
“Exercisability is conditional only on performing service through the vesting date” (i.e., the requisite service period equals the vesting period).
“If an employee terminates service prior to vesting, the employee would forfeit the share options.”
“If an employee terminates service after vesting, the employee would have a limited time to exercise the share options (typically 30–90 days).”
“The share options are nontransferable and nonhedgeable.”

If an award has a performance or market condition, it would not be considered a plain-vanilla option. Entities should evaluate all awards to determine whether they qualify as plain-vanilla options.

The SEC staff believes that public entities should stop using the simplified method for stock option grants if more detailed external information about exercise behavior becomes available. In addition, the staff issues comments related to the use of the simplified method and, in certain instances, registrants have been asked to explain why they believe that they were unable to reasonably estimate the expected term on the basis of their historical stock option exercise information.

In accordance with the SEC’s guidance in Question 6 of SAB Topic 14.D.2, a registrant that uses the simplified method should disclose in the notes to its financial statements (1) that the simplified method was used, (2) the reason the method was used, (3) the types of stock option grants for which the simplified method was used if it was not used for all stock option grants, and (4) the period(s) for which the simplified method was used if it was not used in all periods presented.

5.8.1.2.3.2 Expected Volatility

ASC 718-10-55-36 states, in part:

Volatility is a measure of the amount by which a financial variable, such as share price, has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. Option-pricing models require expected volatility as an assumption because an option’s value is dependent on potential share returns over the option’s term. The higher the volatility, the more the returns on the shares can be expected to vary — up or down.

ASC 718 does not require entities to use a single method for estimating the expected volatility of the underlying share price; rather, ASC 718-10-55-35 states that the objective of estimating such volatility is “to determine the assumption about expected volatility that marketplace participants would be likely to use in determining an exchange price for an option.” ASC 718-10-55-37 lists factors that entities would consider in estimating the expected volatility of the underlying share price. The method selected to perform the estimation should be applied consistently from period to period, and entities should adjust the factors or assign more weight to an individual factor only on the basis of objective information that supports such adjustments. The interpretive response to Question 1 of SAB Topic 14.D.1 notes that entities should incorporate into the estimate any relevant new or different information that would be useful. Further, they should “make good faith efforts to identify and use sufficient information in determining whether taking historical volatility, implied volatility or a combination of both into account will result in the best estimate of expected volatility” of the underlying share price.

Historical volatility of the underlying share price — Entities typically value stock options by using the historical volatility of the underlying share price. Under a closed-form model, such volatility is based on the most recent volatility of the share price over the expected term of the option; under a lattice model, it is based on the contractual term. ASC 718-10-55-37(a) states that an entity may disregard the volatility of the share price for an identifiable period if the volatility resulted from a condition (e.g., a failed takeover bid) specific to the entity and the condition “is not expected to recur during the expected or contractual term.” If the condition is not specific to the entity (e.g., general market declines), the entity generally would not be allowed to disregard or place less weight on the volatility of its share price during that period unless objectively verifiable evidence supports the expectation that market volatility will revert to a mean that will differ materially from the volatility during the specified period. The SEC staff believes that an entity’s decision to disregard a period of historical volatility should be based on one or more discrete and specific historical events that are not expected to occur again during the term of the option. In addition, the entity should not give recent periods more weight than earlier periods.
In certain circumstances, an entity may rely exclusively on historical volatility. However, because the objective of estimating expected volatility is to ascertain the assumptions that marketplace participants are likely to use, exclusive reliance may not be appropriate if there are future events that could reasonably affect expected volatility (e.g., a future merger that was recently announced). In addition, an entity that is valuing a spring-loaded award would consider whether it should factor material nonpublic information into its determination of historical volatility.
Implied volatility of the underlying share price — The implied volatility of the underlying share price is not the same as the historical volatility of the underlying share price because it is derived from the market prices of an entity’s traded options or other traded financial instruments with option-like features and not from the entity’s own shares. Entities can use the Black-Scholes-Merton formula to calculate implied volatility by including the fair value of the option (i.e., the market price of the traded option) and other inputs (stock price, exercise price, expected term, dividend rate, and risk-free interest rate) in the calculation and solving for volatility. When valuing employee or nonemployee stock options, entities should carefully consider whether the implied volatility of a traded option is an appropriate basis for the expected volatility of the underlying share price. For example, traded options usually have much shorter terms than employee or nonemployee stock options, and the calculated implied volatility may not take into account the possibility of mean reversion. To compensate for mean reversion, entities use statistical tools for calculating a long-term implied volatility. For example, entities with traded options whose terms range from 2 to 12 months can plot the volatility of these options on a curve and use statistical tools to plot a long-term implied volatility for a traded option with an expected or a contractual term equal to an employee or nonemployee stock option.
Generally, entities that can observe sufficiently extensive trading of options and can therefore plot an accurate long-term implied volatility curve should place greater weight on implied volatility than on the historical volatility of their own share price (particularly if they do not meet the SEC’s conditions for relying exclusively on historical volatility). That is, a traded option’s volatility is more informative in the determination of expected volatility of an entity’s stock price than historical stock price volatility, since option prices take into account the option trader’s forecasts of future stock price volatility. In determining the extent of reliance on implied volatility, an entity should consider the volume of trading in its traded options and its underlying shares, the ability to synchronize the variables used to derive implied volatility (as close to the grant date of employee or nonemployee stock options as reasonably practicable), the similarity of the exercise prices of its traded options to its employee and nonemployee stock options, and the length of the terms of its traded options and employee or nonemployee stock options. In addition, an entity that is valuing a spring-loaded award would consider whether material nonpublic information affects the extent of reliance on implied volatility when estimating the expected volatility.
Limitations on availability of historical data — Public entities should compare the length of time an entity’s shares have been publicly traded with the expected or contractual term of the option. A newly public entity may also consider the expected volatility of the share prices of similar public entities. In determining comparable public entities, the newly public entity would consider factors such as industry, stage of life cycle, size, and financial leverage.
Nonpublic entities may also base the expected volatility of their share prices on the expected volatility of similar public entities’ share prices, and they may consider the same factors as those described above for a newly public entity. When a nonpublic entity is unable to reasonably estimate its entity-specific volatility or that of similar public entities, it may use a calculated value.
Data intervals — An entity that considers the historical volatility of its share price when estimating the expected volatility of its share price should use intervals for price observations that (1) are appropriate on the basis of its facts and circumstances (e.g., given the frequency of its trades and the length of its trading history) and (2) provide a basis for a reasonable estimate of a fair-value-based measure. Daily, weekly, or monthly price observations may be sufficient; however, if an entity’s shares are thinly traded, weekly or monthly price observations may be more appropriate than daily price observations.
Changes in corporate and capital structure — An entity’s corporate and capital structure could affect the expected volatility of its share price (e.g., share price volatility tends to be higher for highly leveraged entities). In estimating expected volatility, an entity should take into account significant changes to its corporate and capital structure, since the historical volatility of a share price for a period in which the entity was, for example, highly leveraged may not represent future periods in which the entity is not expected to be highly leveraged (or vice versa).

The SEC staff believes entities that have appropriate traded financial instruments from which they can derive an implied volatility should generally consider this measure. Further, depending on the extent to which these financial instruments are actively traded, more reliance or exclusive reliance on implied volatility may be appropriate because implied volatility reflects market expectations of future volatility.

SAB Topic 14.D.1 also addresses circumstances in which it is acceptable to rely exclusively on either historical volatility or implied volatility. To rely exclusively on historical volatility, an entity must:

Have “no reason to believe that its future volatility over the expected or contractual term, as applicable, is likely to differ from its past.”
Perform the computation by using a “simple average calculation method.”
Use a “sequential period of historical data at least equal to the expected or contractual term . . . , as applicable.”
Apply “[a] reasonably sufficient number of price observations . . . , measured at a consistent point throughout the applicable historical period.”
Consistently apply this approach.

To rely exclusively on implied volatility, an entity must:

Use a valuation model for employee stock options “that is based upon a constant volatility assumption.”
Derive the implied volatility from “options that are actively traded.”
Measure the “market prices (trades or quotes) of both the traded options and underlying shares at a similar point in time to each other and on a date reasonably close to the fair value measurement date of the share options.”
Use traded options whose (1) exercise prices “are both . . . near-the-money and . . . close to the exercise price of the share options” and (2) “remaining maturities . . . are at least one year.”
Ensure “material nonpublic information that would be considered in a marketplace participant’s expectation of future volatility does not exist.”
Consistently apply this approach.

If an entity is newly public or nonpublic, it may have limited historical data and no other traded financial instruments from which to estimate expected volatility. In such cases, as discussed in the SEC guidance in SAB Topic 14.D.1, it may be appropriate for the entity to base its estimate of expected volatility on the historical, expected, or implied volatility of comparable entities.

Further, when valuing spring-loaded awards, an entity needs to determine whether a marketplace participant would consider the material nonpublic information when estimating expected volatility. Material nonpublic information may affect the extent of reliance on implied volatility and may need to be factored into the determination of implied and historical volatility.

5.8.1.2.3.3 Current Price of the Underlying Share

Under SAB 120, an entity that grants a share-based payment award while in possession of positive material nonpublic information should consider whether adjustments to the current price of the underlying share are appropriate when determining the fair-value-based measure of the award. Any adjustments required as a result of the SAB would be related only to the determination of a fair-value-based measure in accordance with ASC 718 and would not extend to the determination of fair value under ASC 820.

In SAB 120, the SEC staff acknowledges that entities should use significant judgment when determining whether an adjustment to the observable market price is necessary. The SAB notes that it is not uncommon for entities to possess nonpublic information when entering into share-based payment transactions and that an observable market price on the grant date is “generally a reasonable and supportable estimate of the current price of the underlying share in a share-based payment transaction, for example, when estimating the grant-date fair value of a routine annual grant to employees that is not designed to be spring-loaded.” However, the SAB does not limit an entity’s consideration of grants to those that are nonroutine. Therefore, an entity should have policies and procedures in place so that it can identify when a grant is spring-loaded in nature.

5.8.2 Other Pre-IPO Issues

5.8.2.1 Repurchase Features

Because a nonpublic entity’s common stock is not publicly traded, share-based payment awards often include repurchase features related to the underlying stock to provide grantees with liquidity and to limit the number of holders of stock before an IPO. These features typically are in the form of a (1) call right, in which a nonpublic entity has the right (but not the obligation) to repurchase stock from a grantee for cash, or (2) put right, which gives the grantee the right to require the nonpublic entity to repurchase the stock for cash. The repurchase price associated with the call and put options can vary (e.g., fair value, fixed amount, cost, formula value). In addition, repurchase features often expire or are otherwise eliminated upon an IPO (i.e., when the underlying stock is liquid). An entity should evaluate repurchase features to determine whether they affect the classification of share-based payment awards as either a liability or equity award.

ASC 718-10

25-9 Topic 480 does not apply to outstanding shares embodying a conditional obligation to transfer assets, for example, shares that give the grantee the right to require the grantor to repurchase them for cash equal to their fair value (puttable shares). A put right may be granted to the grantee in a transaction that is related to a share-based compensation arrangement. If exercise of such a put right would require the entity to repurchase shares issued under the share-based compensation arrangement, the shares shall be accounted for as puttable shares. A puttable (or callable) share awarded to a grantee as compensation shall be classified as a liability if either of the following conditions is met:

The repurchase feature permits the grantee to avoid bearing the risks and rewards normally associated with equity share ownership for a reasonable period of time from the date the good is delivered or the service is rendered and the share is issued. A grantee begins to bear the risks and rewards normally associated with equity share ownership when all the goods are delivered or all the service has been rendered and the share is issued. A repurchase feature that can be exercised only upon the occurrence of a contingent event that is outside the grantee’s control (such as an initial public offering) would not meet this condition until it becomes probable that the event will occur within the reasonable period of time.
It is probable that the grantor would prevent the grantee from bearing those risks and rewards for a reasonable period of time from the date the share is issued.

For this purpose, a period of six months or more is a reasonable period of time.

An award with a call right is classified as a liability if it is probable that the employer would prevent the grantee from bearing the risks and rewards of equity ownership for at least six months from the date the good is delivered or the requisite service is rendered and the share is issued or issuable. Similarly, an award with a put right is classified as a liability if it permits a grantee to avoid bearing the risks and rewards of equity ownership for at least six months from the date the good is delivered or the requisite service is rendered and the share is issued or issuable. Unlike a call right, the probability that a put right will be exercised is generally not considered (i.e., exercise is generally assumed).

The classification analysis could be complex and depends on whether the repurchase price is at fair value or another amount. If the repurchase price is not at fair value, the six-month holding period is not relevant, and the repurchase feature should generally be considered for as long as it is outstanding. Additional analysis is required, but the award is generally classified as a liability until the repurchase feature expires since it is generally probable that a call feature allowing the entity to repurchase stock at a price that is below fair value or potentially below fair value will be exercised. In addition, repurchase features are often exercisable only upon the occurrence of a specified future event (i.e., a triggering event), such as termination of employment. While the probability of the triggering event is analyzed in the determination of the appropriate classification, if the triggering event is within the grantee’s control (e.g., voluntary termination) and is related to a put right, that triggering event is generally ignored. See Section 5.3 of Deloitte’s Roadmap Share-Based Payment Awards for considerations related to the impact of repurchase features on the classification of share-based payment awards.

For put rights, an entity undergoing an IPO must consider the requirements of ASC 480-10-S99-3A and SAB Topic 14.E. SAB Topic 14.E requires that an SEC registrant present share-based payment awards (otherwise classified as equity) subject to redemption features not solely within the control of the issuer as temporary (or “mezzanine”) equity. Classification in temporary equity is required even if the awards qualify for equity classification under ASC 718 (e.g., an award that is contingently puttable by the grantee at the then-current fair value more than six months after vesting or share issuance). Puttable awards classified as temporary equity should be recognized at their redemption value over the requisite service period or nonemployee’s vesting period. Such awards are remeasured at the end of each reporting period unless exercise is contingent on an event whose occurrence is not probable.

5.8.2.2 Substantive Classes of Equity

Nonpublic entities (often limited partnerships or limited liability companies) may grant special classes of equity, frequently referred to as “profits interests.” In many cases, a waterfall calculation is used to determine the payout to the different classes of shares or units. While arrangements vary, the waterfall calculation is often performed to allocate distributions and proceeds to the profits interests only after specified amounts (e.g., multiple of invested capital) or specified returns (e.g., internal rate of return [IRR] on invested capital) are first allocated to the other classes of equity. In addition, future profitability threshold amounts, or “hurdles,” must be cleared before the grantee receives distributions so that, for tax purposes on the grant date, the award has zero liquidation value. However, for accounting purposes, the award would have a fair value in accordance with ASC 718. In certain cases, distributions on and realization of value from profits interests are expected only from the proceeds from a liquidity event such as a sale or IPO of the entity, provided that the sale or IPO exceeds a target hurdle rate.

While the legal and economic form of these awards can vary, they should be accounted for on the basis of their substance. If an 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 and ASC 450 for employee arrangements).

In a speech at the 2006 AICPA Conference on Current SEC and PCAOB Developments, Joseph Ucuzoglu, then a professional accounting fellow in the SEC’s Office of the Chief Accountant, discussed the SEC staff’s observations related to special classes of equity and associated financial reporting considerations. Specifically, he stated:

Public companies often create special classes of stock to more closely align the compensation of an employee with the operating performance of a portion of the business with which he or she has oversight responsibility. That is, rather than granting an equity interest in the parent company, employees are granted instruments whose value is based predominantly on the operations of a particular subset of the parent’s operations. The staff has observed the use of these arrangements in diverse industries, ranging from the grant of an interest in a group of restaurants that an employee oversees, to the grant of an interest in a particular investment fund that an employee manages.

Similarly, pre-IPO companies often create special classes of stock to provide employees with an opportunity to participate in any appreciation realized through a future initial public offering or sale of the company, with limited opportunity for gain if no liquidity event occurs. In order to accomplish this objective, the special class is often subordinate in both dividend rights and liquidation preference to the company’s main class of stock, and may have little or no claim to the underlying net assets of the company. In many cases, the terms of these instruments mandate conversion into the entity’s main class of common stock upon the completion of an IPO.

Several accounting issues arise when a special class of stock is granted to employees. First and foremost, one must look through the legal form of the instrument to determine whether the instrument is in fact a substantive class of equity for accounting purposes, or is instead similar to a performance bonus or profit sharing arrangement. When making this determination, all relevant features of the special class must be considered. There are no bright lines or litmus tests. When few if any assets underlie the special class, or the holder’s claim to those assets is heavily subordinated, the arrangement often has characteristics of a performance bonus or profit-sharing arrangement. Instruments that provide the holder with substantive voting rights and pari passu dividend rights are at times indicative of an equity interest. Consideration should also be given to any investment required and any put and call rights that may limit the employee’s downside risk or provide for cash settlement. Many of these factors were contained in Issues 28 and 40 of EITF Issue 00-23, which provided guidance on the accounting under Opinion 25 for certain of these arrangements.

When the substance of the instrument is that of a performance bonus or profit sharing arrangement, it should be accounted for as such. In those circumstances, any returns to the employee should be reflected as compensation expense, not as equity distributions or minority interest expense. Further, if the employee remitted consideration at the outset of the arrangement in exchange for the instrument, such consideration should generally be reflected in the balance sheet as a deposit liability.

On the other hand, when the substance of the arrangement is in fact that of a substantive class of equity, questions often arise as to the appropriate valuation of the instrument for the purpose of recording compensation expense pursuant to FASB Statement No. 123R. These instruments, by design, often derive all or substantially all of their value from the right to participate in future share price appreciation or profits. Accordingly, the staff has rejected the use of valuation methodologies that focus predominantly on the amount that would be realized by the holder in a current liquidation, as such an approach fails to capture the substantial upside potential of the security. [Footnotes omitted]

Although Issues 28 and 40 of EITF Issue 00-23 (referred to in the speech above) were superseded and nullified by FASB Statement 123(R) (codified in ASC 718), the indicators provided in them are useful in the determination of whether profits interests represent a substantive class of equity. Those indicators, as well as others, include the legal form of the instrument (a profits interest can only be a substantive class of equity if it is legal-form equity); distribution rights, particularly after vesting; claims to the residual assets of the entity upon liquidation; substantive net assets underlying the interest; retention of vested interests upon termination; any investment required to purchase the shares or units; transferability after vesting; voting rights commensurate with those of other substantive equity holders; an entity’s intent in issuing the interest (i.e., whether the entity is attempting to align the holder’s interests with those of other substantive equity holders); provisions for realization of value; and repurchase features that may affect exposure to risks and rewards.

A key focus in the determination of whether profits interests represent a substantive class of equity is the ability to retain residual interests upon vesting (e.g., after termination), including the ability to realize value that is tied to the underlying value of the entity’s net assets, through distributions that are based on an entity’s profitability and operations as well as on any liquidity event, even if through a lower level of waterfall distributions. By contrast, in a profit-sharing arrangement, a grantee typically is only able to participate in the entity’s profits while providing goods or services to the entity, and a residual interest is not retained upon termination. A profit-sharing arrangement may also contain provisions (e.g., repurchase features) that limit the grantee’s risks and rewards (e.g., a repurchase feature that, upon termination of employment, is at cost or a nominal amount).

In addition, not all the indicators described above are given equal weight. While voting rights and transferability may be indicative of an equity interest, the absence of such features would not preclude the interest from being considered a substantive class of equity. Nonpublic entities frequently issue equity interests that lack voting rights, particularly to noncontrolling interest holders, and have transferability restrictions. Further, if a grantee does not make an initial investment to purchase an equity interest, the equity interest may still be a substantive class of equity. In that circumstance, consideration for the shares or units is in the form of goods or services.

In determining whether a vested residual interest is retained after termination, an entity typically focuses on what happens to the interest if the grantee is an employee who voluntarily terminates employment without good reason9 or if the grantee is a nonemployee who ceases to provide goods or services. For example, if an employee award is legally vested but is substantively forfeited upon voluntary termination without good reason (e.g., the entity can repurchase the legally vested award at the lower of cost or fair value upon such a termination event), the award will most likely be a profit-sharing arrangement (see Section 3.4.3 of Deloitte’s Roadmap Share-Based Payment Awards for a discussion of repurchase features that function as vesting conditions). By contrast, if an employee award is legally vested but substantively forfeited only upon termination for cause (e.g., the entity can repurchase the legally vested award at the lower of cost or fair value upon such a termination event), that feature would not affect the analysis since it functions as a clawback provision (see Section 3.9 of Deloitte’s Roadmap Share-Based Payment Awards for a discussion of repurchase features that function as clawback provisions).

In determining whether an award is a profit-sharing arrangement, an entity should consider the substance of an award rather than its form. For example, an award may legally vest immediately under an agreement; however, the vesting may not be substantive if the award cannot be transferred or otherwise monetized until an IPO occurs and the entity can repurchase the award for no consideration if the grantee terminates employment or ceases to provide goods or services before the IPO. Such an award would be likely to have a substantive performance condition that affects vesting (i.e., an IPO is a vesting condition) even though the award was deemed “immediately vested” according to the agreement.

From a valuation standpoint, nonpublic entities should consider whether the profits interests that represent a substantive class of equity have no value on the grant date. For example, if the entity were liquidated on the grant date, the waterfall calculation would result in no payment to the special class. However, in a manner consistent with the SEC staff’s speech above, the profits interests generally have a fair value because of the upside potential of the equity.

Further, from a classification standpoint, even if a nonpublic entity concludes that the profits interests are subject to the guidance in ASC 718, the entity would still need to assess the conditions in ASC 718-10-25-6 through 25-19A to determine whether the award is equity- or liability-classified.

5.8.2.3 IPO Vesting Conditions

Certain share-based payment awards may vest only upon the occurrence of an IPO, which represents a performance condition. If the holder of the awards is no longer providing goods or services (e.g., an employee had retired) before an IPO, the awards are forfeited.10

ASC 718-10 — Glossary

Performance Condition

A condition affecting the vesting, exercisability, exercise price, or other pertinent factors used in determining the fair value of an award that relates to both of the following:

Rendering service or delivering goods for a specified (either explicitly or implicitly) period of time
Achieving a specified performance target that is defined solely by reference to the grantor’s own operations (or activities) or by reference to the grantee’s performance related to the grantor’s own operations (or activities).

Attaining a specified growth rate in return on assets, obtaining regulatory approval to market a specified product, selling shares in an initial public offering or other financing event, and a change in control are examples of performance conditions. A performance target also may be defined by reference to the same performance measure of another entity or group of entities. For example, attaining a growth rate in earnings per share (EPS) that exceeds the average growth rate in EPS of other entities in the same industry is a performance condition. A performance target might pertain to the performance of the entity as a whole or to some part of the entity, such as a division, or to the performance of the grantee if such performance is in accordance with the terms of the award and solely relates to the grantor’s own operations (or activities).

ASC 718-10

25-20 Accruals of compensation cost for an award with a performance condition shall be based on the probable outcome of that performance condition — compensation cost shall be accrued if it is probable that the performance condition will be achieved and shall not be accrued if it is not probable that the performance condition will be achieved. If an award has multiple performance conditions (for example, if the number of options or shares a grantee earns varies depending on which, if any, of two or more performance conditions is satisfied), compensation cost shall be accrued if it is probable that a performance condition will be satisfied. In making that assessment, it may be necessary to take into account the interrelationship of those performance conditions. Example 2 (see paragraph 718-20-55-35) provides an illustration of how to account for awards with multiple performance conditions.

In accordance with ASC 718, compensation cost should be recorded for a share-based payment award only if an entity determines that the achievement of the performance condition is probable. Generally, compensation cost is not recognized for awards that vest upon certain liquidity events, such as a change in control or an IPO, until the event takes place. That is, a change in control or an IPO is generally not probable until it actually occurs. This position is consistent with the guidance in ASC 805-20-55-50 and 55-51 on liabilities that are triggered upon the consummation of a business combination. Therefore, compensation cost is not recognized for an award that only vests upon an IPO until the IPO occurs.

ASC 718-10 — Glossary

Market Condition

A condition affecting the exercise price, exercisability, or other pertinent factors used in determining the fair value of an award under a share-based payment arrangement that relates to the achievement of either of the following:

A specified price of the issuer’s shares or a specified amount of intrinsic value indexed solely to the issuer’s shares
A specified price of the issuer’s shares in terms of a similar (or index of similar) equity security (securities). The term similar as used in this definition refers to an equity security of another entity that has the same type of residual rights. For example, common stock of one entity generally would be similar to the common stock of another entity for this purpose.

An award may vest on the basis of the occurrence of both an IPO and a specified rate of return on the entity’s stock. For example, an award vests upon an IPO as long as the IPO price results in an IRR of a certain percentage on certain shareholders’ initial investment in the entity. This type of award contains both a performance condition (IPO) and a market condition (achievement of a specified rate of return on the entity’s stock). Although performance conditions are assessed for probability, with compensation cost recognized on the basis of whether the performance condition is achieved, market conditions are factored into the grant-date fair-value-based measurement of an award and do not affect whether compensation cost is recognized because a market condition is not a vesting condition.

ASC 718-10

25-21 If an award requires satisfaction of one or more market, performance, or service conditions (or any combination thereof), compensation cost shall be recognized if the good is delivered or the service is rendered, and no compensation cost shall be recognized if the good is not delivered or the service is not rendered. Paragraphs 718-10-55-60 through 55-63 provide guidance on applying this provision to awards with market, performance, or service conditions (or any combination thereof).

Therefore, in such cases, if an IPO occurs but the IRR does not exceed the benchmark, the awards are not earned. However, as long as the holder delivers the good or provides the required service, the grant-date fair-value-based measurement would still be recognized as compensation cost upon the IPO, regardless of whether the market condition is achieved, because (1) the requisite service is rendered or the good is delivered and the performance condition is met and (2) the risk of not attaining the market condition was already considered in the grant-date fair-value-based calculation.

5.8.2.4 Escrowed Share Arrangements

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

As indicated in ASC 718-10-S99-2, the SEC staff has historically expressed the view that escrowed share arrangements such as these are presumed to be compensatory and equivalent to reverse stock splits followed by the grant of restricted stock, subject to certain conditions (e.g., service, performance, or market conditions). If the release of shares is tied to continued employment, the presumption cannot be overcome. In addition, even if the entity is not directly a party to the arrangement (e.g., when the arrangement is only between shareholders and new investors), the arrangement should be reflected in the entity’s financial statements.

However, the SEC staff has stated that in certain circumstances, the presumption that an arrangement is compensation can be overcome. ASC 718-10-S99-2 states that to identify those circumstances, an entity should assess the substance of the escrowed share arrangement to determine whether it was “entered into for purposes unrelated to, and not contingent upon, continued employment.” For example, as a result of concerns related to the entity’s value, investors may require certain shareholders to participate in an escrowed share arrangement before the entity can raise financing. Further, investors may require the entity to achieve certain performance targets (e.g., an EBITDA target over a specified period) before the shares can be released. If the arrangement also requires continued employment, the arrangement is considered compensatory. However, if continued employment is not required (either explicitly or implicitly), the entity should consider all relevant facts and circumstances to determine whether the substance of the arrangement is unrelated to employee compensation.

5.8.3 Modifications

Share-based payment awards are frequently modified in anticipation of an IPO. Any change in the terms or conditions of a share-based payment award represents a modification. Modified awards are viewed as an exchange of the original award for a new award. For an equity award measured at intrinsic value, the change in compensation cost should be measured by comparing the intrinsic value of the award immediately after the modification with the intrinsic value immediately before the modification. When an equity-classified award is modified and the original award was expected to vest on the modification date, an entity must compare the fair-value-based measurement of the award immediately before the modification with the fair-value-based measurement of the award immediately after the modification. Any incremental compensation cost must be recognized over the remaining vesting period. In addition, at a minimum, the original grant-date fair-value-based measure must be recognized. Therefore, total recognized compensation cost attributable to an award that has been modified is (1) the grant-date fair-value-based measure of the original award for which the required service has been provided (i.e., the number of awards that have been earned) or is expected to be provided and (2) any incremental compensation cost conveyed to the holder of the award as a result of the modification. In contrast, if the original award was not expected to vest on the modification date, the original grant-date fair-value-based measure is ignored and compensation cost is recognized on the basis of the fair-value-based measure of the new award on the modification date.

Modification accounting is not applied if the fair-value-based measure, vesting conditions, and classification of an award are the same immediately before and after the modification.

ASC 718-20

35-3 Except as described in paragraph 718-20-35-2A, a modification of the terms or conditions of an equity award shall be treated as an exchange of the original award for a new award. In substance, the entity repurchases the original instrument by issuing a new instrument of equal or greater value, incurring additional compensation cost for any incremental value. The effects of a modification shall be measured as follows:

Incremental compensation cost shall be measured as the excess, if any, of the fair value of the modified award determined in accordance with the provisions of this Topic over the fair value of the original award immediately before its terms are modified, measured based on the share price and other pertinent factors at that date. As indicated in paragraph 718-10-30-20, references to fair value throughout this Topic shall be read also to encompass calculated value. The effect of the modification on the number of instruments expected to vest also shall be reflected in determining incremental compensation cost. The estimate at the modification date of the portion of the award expected to vest shall be subsequently adjusted, if necessary, in accordance with paragraph 718-10-35-1D or 718-10-35-3 and other guidance in Examples 14 through 15 (see paragraphs 718-20-55-107 through 55-121).
Total recognized compensation cost for an equity award shall at least equal the fair value of the award at the grant date unless at the date of the modification the performance or service conditions of the original award are not expected to be satisfied. Thus, the total compensation cost measured at the date of a modification shall be the sum of the following:
1. The portion of the grant-date fair value of the original award for which the promised good is expected to be delivered (or has already been delivered) or the service is expected to be rendered (or has already been rendered) at that date
2. The incremental cost resulting from the modification.
Compensation cost shall be subsequently adjusted, if necessary, in accordance with paragraph 718-10-35-1D or 718-10-35-3 and other guidance in Examples 14 through 15 (see paragraphs 718-20-55-107 through 55-121).
A change in compensation cost for an equity award measured at intrinsic value in accordance with paragraph 718-20-35-1 shall be measured by comparing the intrinsic value of the modified award, if any, with the intrinsic value of the original award, if any, immediately before the modification.

Many modifications are made before an IPO occurs but are not effective unless the IPO occurs. While the date on which the contingent modification is made is generally the modification date in the measurement of compensation cost, the accounting consequence may not be recognized until the IPO’s effective date if the modification depends on the occurrence of the IPO. For example, an award could be modified to increase the quantity of shares underlying the award upon a successful IPO. In this circumstance, any additional compensation cost (as determined on the modification date) would not be recognized until the IPO is effective since IPOs are generally not considered probable until they occur.

In addition, there could be circumstances in which changes associated with an award that are not modifications result in accounting consequences. For example, an entity could grant an award with a repurchase feature that causes the award to be liability-classified. If the original terms contain a provision that the repurchase feature will expire upon an IPO, however, the award would be reclassified from liability to equity upon the IPO.

5.8.4 Disclosures

ASC 718-10

50-1 An entity with one or more share-based payment arrangements shall disclose information that enables users of the financial statements to understand all of the following:

The nature and terms of such arrangements that existed during the period and the potential effects of those arrangements on shareholders
The effect of compensation cost arising from share-based payment arrangements on the income statement
The method of estimating the fair value of the equity instruments granted (or offered to grant), during the period
The cash flow effects resulting from share-based payment arrangements.

This disclosure is not required for interim reporting. For interim reporting see Topic 270. See Example 9 (paragraphs 718-10-55-134 through 55-137) for an illustration of this guidance.

ASC 718-10-50-1 highlights disclosure objectives related to share-based compensation arrangements, and ASC 718-10-50-2 lists the minimum information needed to achieve these objectives. The SEC staff frequently comments on the disclosures associated with share-based compensation, including the minimum disclosure requirements and significant valuation assumptions. For additional observations related to frequently issued SEC staff comments, see Deloitte’s Roadmap SEC Comment Letter Considerations, Including Industry Insights.

5.8.4.1 Cheap Stock Disclosures

Typically, a registrant undergoing an IPO identifies share-based compensation as a CAE because the lack of a public market for the pre-IPO shares makes the estimation process complex and subjective. For more information about cheap stock, see Section 5.8.1.1.4.

Further, paragraph 7520.1 of the FRM outlines considerations related to the “estimated fair value of [stock that] is substantially below the IPO price” (often referred to as “cheap stock”). 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 had historically asked registrants to expand the disclosures in their CAEs to add information about the valuation methods and assumptions used for share-based compensation in an IPO. In 2014, however, the staff updated Section 9520 of the FRM to indicate that registrants should significantly reduce, in the CAEs section of MD&A, their disclosures about share-based compensation and the valuation of pre-IPO common stock. Nevertheless, paragraph 9520.2 of the FRM notes that the SEC staff may continue to request that entities “explain the reasons for valuations that appear unusual (e.g., unusually steep increases in the fair value of the underlying shares leading up to the IPO).” Such requests are meant to ensure that a registrant’s analysis and assessment support its accounting for share-based compensation; they do not necessarily indicate that the registrant’s disclosures need to be enhanced.

At the Practising Law Institute’s “SEC Speaks in 2014” Conference, the SEC staff discussed the types of detailed disclosures it had observed in IPO registration statements that had prompted the updates to Section 9520 of the FRM. The staff noted that registrants have historically included:

A table of equity instruments issued during the past 12 months.
A description of the methods used to value the registrant’s pre-IPO common stock (i.e., income approach or market approach).
Detailed disclosures about certain select assumptions used in the valuation.
Discussion of changes in the fair value of the entity’s pre-IPO common stock (i.e., registrants have historically included each grant leading up to the IPO, resulting in repetitive disclosures).

The staff indicated that despite the volume of share-based compensation information included in IPO filings, disclosures of such information were typically incomplete because registrants did not discuss all assumptions related to their common-stock valuations. Further, disclosures about registrants’ pre-IPO common-stock valuations were not relevant after an IPO and were generally removed from their periodic filings after the IPO. The SEC staff expressed the view that in addition to reducing the volume of information, streamlined share-based compensation disclosures make reporting more meaningful. The staff also indicated that by eliminating unnecessary information, registrants could reduce many of their prior disclosures “down to one paragraph.”

At the conference, the SEC staff also provided insights into how registrants would be expected to apply the guidance in paragraph 9520.1 of the FRM and thereby reduce the share-based compensation disclosures in their IPO registration statements:

The staff does not expect much detail about the valuation method registrants used to determine the fair value of their pre-IPO shares. A registrant need only state that it used the income approach, the market approach, or a combination of both.
Further, while registrants are expected to discuss the nature of the material assumptions they used, they would not be required to quantify such assumptions. For example, if a registrant used an income approach involving a discounted cash flow method, it would only need to provide a statement indicating that a discounted cash flow method was used and involved cash flow projections that were discounted at an appropriate rate. No additional details would be needed.
Registrants would have to include a statement indicating that the estimates in their share-based compensation valuations are highly complex and subjective but would not need to provide additional details about the estimates. Registrants would also need to include a statement disclosing that such valuations and estimates will no longer be necessary once the entity goes public because it will then rely on the market price to determine the fair value of its common stock.

The staff emphasized that its ultimate concern is whether registrants correctly accounted for pre-IPO share-based compensation. Accordingly, the staff will continue to ask them for supplemental information to support their valuations and accounting conclusions — especially when the fair value of an entity’s pre-IPO common stock is significantly less than the expected IPO price.11

Footnotes

A nonpublic entity’s use of calculated value does not represent an accounting policy election, since a nonpublic entity must use calculated value to measure its awards if it is not practicable for it to estimate the expected volatility of its share price. Thus, once an entity is able to estimate the expected volatility of its own share price or it becomes a public entity, the entity should switch from using a calculated value to using a fair-value-based measure and should account for the change as a change in accounting estimate under ASC 250.

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

The definition of “public entity” in ASC 718 encompasses entities that make “a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market.” The definition therefore includes entities that have filed an initial registration statement with the SEC before the effective date of an IPO.

A significant demotion, a significant reduction in compensation, or a significant relocation are commonly considered “good reasons” for termination.

ASC 718-10-30-28 specifies that a share-based payment award with established performance targets that affect vesting and that could be achieved after a grantee completes the requisite service or a nonemployee’s vesting period (i.e., the grantee would be eligible to vest in the award regardless of whether the grantee is delivering goods or rendering service on the date the performance target could be achieved) should be treated as a performance condition that is a vesting condition. For example, the terms of an award to an employee may allow the award to vest upon completion of an IPO (i.e., the performance target) even if the IPO occurs after the employee has completed the requisite service period.

At the conference, the SEC staff noted that valuations that appear unusual may be attributable to the peer companies selected when a market approach is used. Specifically, the staff indicated that there are often inconsistencies between the peer companies used by registrants and those used by the underwriters, which result in differences in the valuations. Accordingly, the staff encouraged registrants to talk to the underwriters “early and often” to avoid such inconsistencies.