2.21 Share-Based Payment Awards

The SEC staff often focuses on “cheap stock”14 issues in connection with a nonpublic entity’s preparation for an IPO. The 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 staff will challenge valuations that are significantly lower than prices paid by investors to acquire similar stock. If the differences cannot be reconciled, a nonpublic entity may be required to record a cheap-stock charge. Since share-based payments are often a compensation tool to attract and retain employees or nonemployees, a cheap-stock charge could be material and, in some cases, lead to a restatement of the financial statements.

An entity preparing for an IPO should refer to paragraph 7520.1 of the FRM, which outlines considerations for registrants when the “estimated fair value of the stock is substantially below the IPO price.” In such situations, registrants should be able to reconcile the change in the estimated fair value of the underlying equity between the award grant date and the IPO by taking into account, among other things, intervening events and changes in assumptions that support the change in fair value.

The SEC staff has frequently inquired about a registrant’s pre-IPO valuations. Specifically, during the registration statement process, the SEC staff may ask an entity to (1) reconcile its recent fair values with the anticipated IPO price (including significant intervening events), (2) describe its valuation methods, (3) justify its significant valuation assumptions, and (4) discuss the weight it gives to stock sale transactions. We encourage entities planning an IPO in the foreseeable future to use the AICPA’s Accounting and Valuation Guide Valuation of Privately-Held-Company Equity Securities Issued as Compensation (the “AICPA Valuation Guide,” which is commonly referred to as the “Cheap Stock Guide”)15 and to consult with their valuation specialists. Further, they should ensure that their pre-IPO valuations are appropriate and that they are prepared to respond to questions the SEC may have during the registration statement process.

The AICPA Valuation Guide highlights differences between pre-IPO and post-IPO valuations. One significant difference is that the valuation of nonpublic-entity securities often includes a discount for lack of marketability (DLOM). The DLOM can be determined by using several valuation techniques, as described in the AICPA Valuation Guide, and is significantly affected by the underlying volatility of the stock and the period the stock is illiquid.

Typically, a registrant undergoing an IPO of its equity securities identifies share-based compensation as a critical accounting estimate because the lack of a public market for the pre-IPO shares makes the estimation process complex and subjective. The SEC staff had historically asked registrants to expand the disclosures in their critical accounting estimates 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 critical accounting estimates 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 companies “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 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 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 “down to one paragraph” many of their prior disclosures.

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 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.

For further discussion of SEC staff comments related to IPOs, see Chapter 4.

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 (although 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; if so, the nonpublic entity would most likely be required to recognize compensation cost for the excess regardless of whether it is directly involved in the transaction.

It is important for a nonpublic entity to recognize that transactions such as those described above may be subject to the guidance in ASC 718 because the investors are considered holders of an economic interest in the entity. 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.

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.” This may include the grant of profits interests tied to carried interest on a particular investment fund that an employee manages or the grant of profits interests in a private equity backed portfolio company. 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 often is performed to allocate distributions and proceeds to the profits interests only after specified amounts (e.g., multiple of invested capital [MOIC]) 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 that is within the scope of 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).