2.21 Share-Based Payment Awards
2.21.1 Disclosures
Examples of SEC Comments
- Please review the disclosure requirements for
stock-based compensation found at ASC 718-10-50
and provide the following disclosures in future
annual filings:
-
[Please] revise future filings to include the total intrinsic value of options exercised during the year pursuant to ASC 718-10-50-2d2;
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Please disclose the weighted-average remaining contractual term of options currently exercisable pursuant to ASC 718-10-50-2e; and
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Please revise future filings to include the method used to estimate the fair value of all of your options, as well as, the significant assumptions used to determine fair value pursuant to ASC 718-10-50-2b & f.
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- Please tell us your consideration of disclosing the weighted-average grant-date fair value of equity options granted during the years presented. Refer to ASC 718-10-50-2d.1.
- ASC 718-10-50 requires disclosure of “As of the latest balance sheet date presented, the total compensation cost related to nonvested awards not yet recognized and the weighted-average period over which it is expected to be recognized.” Please direct us to or provide us this information and tell us your consideration of disclosing this information.
Registrants should ensure that their disclosures address the following objectives outlined in ASC
718-10-50-1:
- The “nature and terms” of share-based payment arrangements.
- The “effect of [the related] compensation cost . . . on the income statement.”
- The “method of estimating the fair value of the equity instruments granted.”
- The “cash flow effects resulting from share-based payment arrangements.”
Accordingly, the SEC staff’s comments on share-based payment disclosures have focused on items
such as:
- The nature of, and reason for, a modification in the share-based payment award’s terms and how the registrant accounted for that modification.
- The terms and conditions of awards, including vesting conditions and whether grantees are entitled to dividends or dividend equivalents.
- The number of awards that are expected to vest and the assumptions that were used to determine that number.
- The registrant’s valuation method, including significant assumptions used (e.g., volatility, expected term, dividend yield).
- The “weighted-average grant-date fair value” of equity instruments granted during the year.
- The “total intrinsic value of options exercised” during the periods presented.
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The “total compensation cost related to nonvested awards not yet recognized and the weighted-average period over which it is expected to be recognized.”
In its comments about disclosures, the SEC staff has referred to ASC 718-10-50-2, which describes the “minimum information needed to achieve the objectives in paragraph 718-10-50-1.”
In addition, the SEC staff may ask registrants about share-based payment information they are
required to include in a proxy statement (e.g., those disclosures required by Regulation S-K, Item 402).
See Section 3.7 for more information about SEC staff comments on registrants’ proxy statements.
2.21.2 Share-Based Payment Awards Issued by Nonpublic Entities
2.21.2.1 Cheap Stock
Examples of SEC Comments
- Please tell us the estimated IPO price range. To the extent there is a significant difference between the estimated grant-date fair value of your common stock during the past twelve months and the estimated IPO price, please discuss for us each significant factor contributing to the difference.
- Please disclose the dates and fair values for the third-party valuations of your common stock during the periods presented. Clarify the estimated common stock price at the time of the . . . options issuance and explain to us how it relates to the share price in the . . . convertible preferred stock financing. Once you have an estimated offering price or range, please explain to us the reasons for any differences between the recent valuations of your common stock leading up to the IPO and the estimated offering price. This information will help facilitate our review of your accounting for equity issuances including stock compensation and beneficial conversion features.
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):
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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.
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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.
2.21.2.2 Purchases of Shares From Grantees
Examples of SEC Comments
- Please tell us whether you repurchased any common stock, stock options or restricted stock units from employees. If so, tell us, and revise to disclose, if material, how you considered the guidance in ASC 718-20-35-7. Also, tell us how you considered the price paid per share for repurchases in your determination of the fair value of your stock on the date of grant for your stock based compensation.
- Reference is made to the . . . stock sales by employees or former employees. Please explain the business reason(s) that existing investors would pay in excess of fair value for employee shares and whether employees continued to be employed post-sale. . . . Please also explain how you determined fair market value. If based on a valuation model, please explain why the model is a better indication of fair value than the share sale between existing investors and employees. Please also provide any price information on contemporaneous sales of stock to unrelated third parties.
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.
2.21.2.3 Profits Interests and Other Awards Issued by Pass-Through Entities
Example of an SEC Comment
Please provide an analysis supporting your accounting treatment for the Class B equity units in [Company A]
under which you record compensation expense at the time distributions [were] made to Class B holders but not at grant date. In your response, describe the terms of the Class B equity units and refer to specific accounting guidance on which you relied.
Nonpublic entities (often limited partnerships or limited liability companies)
may grant special classes of equity, frequently referred to as “profits
interests.” In many cases, a waterfall calculation is used to determine the
payout to the different classes of shares or units. While arrangements vary,
the waterfall calculation often is 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 on invested capital) are first allocated to the other classes of
equity. In certain cases, distributions on and realization of value from
profits interests are expected only from the proceeds from a liquidity event
such as a sale or IPO of the entity, provided that the sale or IPO exceeds a
target hurdle rate.
While the legal and economic form of these awards can vary, they should be
accounted for on the basis of their substance. If an award has the
characteristics of an equity interest, it represents a substantive class of
equity and should be accounted for under ASC 718; however, an award that is,
in substance, a performance bonus or a profit-sharing arrangement would be
accounted for as such in accordance with other U.S. GAAP (e.g., typically
ASC 710 and ASC 450 for employee arrangements).
2.21.3 Significant Assumptions
Examples of SEC Comments
- Please more fully explain to us why you believe it is appropriate to use the simplified method to estimate the expected life of your stock options. Please also tell us when you expect sufficient historical information to be available to you to determine expected life assumptions and address the impact that your current approach has had on your financial statements. Refer to SAB Topic 14.D.2.
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Please tell us in sufficient detail how you determined it was appropriate to use the simplified method in determining the expected term of your stock option grants. See SAB Topic 14D.
- We note that the expected volatility of your Class A common stock is based on a peer group in the industry in which the Company does business. Please tell us what consideration you gave to using the Company’s historical pricing data in arriving at a volatility assumption. In addition, tell us what consideration you gave to disclosing the reason for the continued reliance on a peer group in the industry in arriving at this assumption. We refer you to ASC 718-10-55-37 and SAB Topic 14.D.1.
As noted above, the SEC staff’s comments have focused on significant assumptions
used in a registrant’s valuation of share-based payment awards, such as
volatility, expected term, and dividend yield. For example, there have been a
number of comments related to the use of the “simplified method” to calculate
the expected term of employee share options. Under ASC 718, the expected term of
an option is a key factor for measuring the option’s fair-value-based amount and
the related compensation cost. Question 6 of SAB Topic 14.D.2 discusses the
simplified method16 of estimating the expected term of “plain-vanilla” share options and
permits a registrant to use the simplified method under certain circumstances if
the registrant “concludes that its historical share option exercise experience
does not provide a reasonable basis upon which to estimate expected term.” The
SEC staff’s comments have focused on a registrant’s use of the simplified
method, and in certain instances, registrants were asked to explain why they
believe that their historical share option experience does not provide a
reasonable basis for estimating the expected term.
In accordance with the staff’s guidance in Question 6, 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 share option grants for which the simplified method was
used if it was not used for all share option grants, and (4) the period(s) for which the simplified method
was used if it was not used in all periods presented.
The estimated volatility of an option is also a key factor for measuring the
option’s fair-value-based amount and the related compensation cost because in an
option pricing model, the option’s value is based on potential share returns
over the option’s term. 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 Question 6 of
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.
The SEC staff’s comments have focused on a registrant’s use of the historical volatility of similar entities,
and in certain instances, registrants were asked to explain why they believe that they did not have
sufficient information about the volatility of their own share price on which to base an estimate of
expected volatility. In accordance with the staff’s guidance in Question 1 of SAB Topic 14.D.1, “[w]hen
circumstances indicate the availability of new or different information that would be useful in estimating
expected volatility, a company should incorporate that information.” That is, once the registrant has
a sufficient amount of historical information regarding the volatility of its share price, or once other
traded financial instruments are available to enable the registrant to derive an implied volatility to
support an estimate of expected volatility, the registrant “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.”
In accordance with the staff’s guidance in Question 5 of SAB Topic 14.D.1, a
registrant should disclose in the notes to its financial statements how it
determined the expected volatility assumption for the assessment of the fair
value of its share options to comply with the minimum disclosure requirement
under ASC 718. For example, at a minimum, the staff would expect a registrant to
disclose (1) whether it used only implied volatility, historical volatility, or
a combination of both and (2) how it determined any significant adjustments to
historical volatility.
Further, a registrant should consider the requirements of Regulation S-K, Item
303(b)(3), regarding critical accounting estimates in MD&A and determine
whether its evaluation of any of the factors listed in Questions 2 and 3 of SAB
Topic 14.D.1, such as consideration of future events in estimating expected
volatility, resulted in an estimate that (1) involves significant uncertainty
and (2) has had or is reasonably likely to have a material impact on the
registrant’s financial statements.
On November 29, 2021, the SEC staff issued SAB
120, which provides the SEC staff’s views on the measurement
and disclosure of certain share-based payment awards granted when entities
possess positive 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 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 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. Given the issuance of SAB
120, the SEC staff may ask registrants about the measurement and disclosure of
spring-loaded awards.
2.21.4 Financial Statement Presentation
Examples of SEC Comments
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Please tell us how your presentation of a separate line item for stock-based compensation complies with SAB Topic 14F.
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Please revise to present the expense related to share-based payment arrangements in the same line or lines as cash compensation paid to the same employees. Further, disclose the amount of this expense included in the specific line items in a parenthetical note to the appropriate income statement line items, on the cash flow statement, or in the footnotes to the financial statements. Refer to SAB Topic 14F.
Under SAB Topic 14.F, share-based compensation expense should be classified in the same manner as
other cash compensation costs, and the presentation should not be driven by the form of consideration
paid. Share-based compensation expense should be allocated to items such as cost of sales, R&D, and
SG&A (as applicable) and should not be separately presented in a single share-based compensation
line item. Further, SAB Topic 14.F states, “Disclosure of this information might be appropriate in a
parenthetical note to the appropriate income statement line items, on the cash flow statement, in the
footnotes to the financial statements, or within MD&A.”
Footnotes
14
“Cheap stock” refers to issuances of equity
securities before an IPO in which the value of the shares is below
the IPO price.
15
The AICPA Valuation Guide provides best-practice
guidance for valuing the equity securities of nonpublic entities. It
discusses, among other topics, possible methods of allocating
enterprise value to underlying securities, enterprise- and
industry-specific attributes that should be considered in the
determination of fair value, best practices for supporting fair
value, and recommended disclosures for a registration statement.
16
Question 6 states that under the simplified method, the
“expected term = ((vesting term + original contractual term) / 2).“