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. There are certain differences under ASC 718 between the
accounting for employee share-based payment awards and the accounting for
nonemployee awards. Because of these differences, it is 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 a nonpublic entity 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.
Nonpublic entities may elect to use a practical expedient 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. ASC 718-10-30-20G 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. In addition, ASC 718-10-30-20G explicitly refers to
other valuation approaches under IRC Section 409A that are presumed to be
reasonable.
Although the SEC has provided transition guidance for entities that elect the
practical expedients related to intrinsic value or calculated value when
changing their status from nonpublic entity to public entity (see Section 5.8.1.2.2), there is no similar
transition guidance related to the practical expedient for the current price
input. 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, 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 try to use a fair-value-based measure to value their
equity-classified awards. 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, a nonpublic entity sometimes 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 expected volatility of the
entity’s 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 under ASC 606) 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, they should ensure that their pre-IPO valuations are
appropriate and that they are prepared to respond to questions the SEC
may have during the registration statement process. 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, or other relevant measurement dates, for share-based payment
awards. As a result, management must assess the current fair value of
the underlying shares as of the measurement 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 Section
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 or modifies 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 provides 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 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 such as limited partnerships, limited
liability companies, or similar pass-through entities may grant special
classes of equity, frequently in the form of “profits interests.” Such
grants may include grants of profits interests tied to carried interest on a
particular investment fund that an employee manages or grants of profits
interests in a portfolio company backed by private equity. 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, 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 therefore 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 National
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. Mr. Ucuzoglu stated that
in determining whether an instrument is a “substantive class of equity for
accounting purposes, or is instead similar to a performance bonus or profit
sharing arrangement,” an entity must “look through” its legal form. He also
indicated that “when making this determination, all relevant features of the
special class must be considered [and that there] are no bright lines or
litmus tests.”
Mr. Ucuzoglu further noted that Issues 28 and 40 of EITF Issue 00-23 “provided guidance on the accounting . . . for certain of these arrangements.” Although FASB Statement 123(R) (codified in ASC 718)
superseded and nullified this guidance, we believe that some of the
indicators identified therein are still relevant and may be useful in the
determination of whether profits interests represent a substantive class of
equity within the scope of ASC 718-10-15-3(a). 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.
- 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.
- 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 contain
provisions (e.g., repurchase features) that limit the grantee’s risks and
rewards upon termination (e.g., a repurchase feature that, upon termination
of employment, is at cost or a nominal amount).
While retention after termination is an important focus in this evaluation,
profits interests retained upon termination may not always represent a
substantive class of equity. For example, certain entities, such as general
partnerships, may grant profits interests that allocate a portion of the
general partnership’s carried interest earned to a grantee for managing a
specific investment or fund of investments that, by design, have a finite
life. In these instances, an entity may conclude that the profits interests
do not represent a substantive class of equity because there are no
substantive net assets underlying the profits interest other than a right to
cash distributions solely on the basis of the realization of a specific
investment or fund of investments.
In addition, while voting rights and transferability are not listed as
indicators above (because they are not always relevant and useful for that
purpose), their presence may suggest the possibility of an equity interest;
however, 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) and the repurchase feature
does not expire upon a liquidity 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).
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.
We would most likely conclude that such an award has 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.
Changing Lanes
In March 2024, the FASB issued ASU
2024-01, which clarifies how an entity
determines whether a profits interest or similar award is (1) within
the scope of ASC 718 or (2) not a share-based payment arrangement
and therefore within the scope of other guidance. The ASU adds to
U.S. GAAP ASC 718-10-55-138 through 55-148, which provide an
illustrative example (Example 10) with four cases (Cases A through
D) that show how an entity should apply the guidance in ASC
718-10-15-3 to determine whether a profits interest award is within
the scope of ASC 718. Since such guidance was not previously
included within U.S. GAAP, the ASU is likely to reduce the diversity
in practice associated with an entity’s scope assessments in
circumstances that are similar to those described in Cases A through
D of Example 10. In the absence of other relevant factors, however,
the conclusions reached in Cases A through D of Example 10 would be
consistent with those that an entity might reach by applying the
guidance above. For other types of arrangements, an entity will have
to consider the guidance above when determining whether a profits
interest is a substantive class of equity within the scope of ASC
718 or a profit-sharing arrangement. See Deloitte’s March 22, 2024,
Heads
Up for more information about ASU 2024-01,
including its effective dates and transition guidance.
From a valuation standpoint, nonpublic entities might 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 the 2006 speech discussed above, Mr. Ucuzoglu noted that
profits interests generally have a fair value because of the upside
potential of the equity. He stated:
[W]hen 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. [Footnote omitted]
Further, from a classification standpoint, once a nonpublic entity concludes
that the profits interests are subject to the guidance in ASC 718 because
they represent a substantive class of equity, the entity would next need to
assess the conditions in ASC 718-10-25-6 through 25-19A to determine whether
the award should be equity- or liability-classified.
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:
- 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
- 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
6
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.
7
Cheap stock refers to the issuance of equity
securities before an IPO in which the value of the shares is
below the IPO price.
8
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.
9
A significant demotion, a significant reduction in compensation, or a
significant relocation is commonly considered a “good reason” for
termination.
10
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.
11
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.