Consideration of Draft Updates to the AICPA Guide on Valuing Equity Securities
The Bottom Line
- When estimating the fair value of equity securities underlying share-based compensation awards, entities should consider the working draft of two chapters released by the AICPA’s Financial Reporting Executive Committee (FinREC) as part of a forthcoming update to its Accounting and Valuation Guide: Valuation of Privately-Held Company Equity Securities Issued as Compensation (the “AICPA Valuation Guide”). The working draft places more emphasis on secondary transactions than does the current edition of the AICPA Valuation Guide, which was released in 2013.
- The working draft addresses the increase in secondary transactions and share repurchases, which are common in technology companies, since the 2013 edition was released.
- FinREC recommends that entities apply the market-based measurement guidance in ASC 8201 to estimate the fair value of equity securities underlying share-based compensation awards. To meet the objectives of such guidance, reporting entities must maximize the use of relevant observable inputs and minimize the use of unobservable inputs.
- Information related to both primary and secondary transactions can be used as relevant observable inputs for estimating the fair value of equity securities underlying share-based compensation awards. Primary transactions involve issuing equity directly from a company to an investor, often including preferred stock with negotiated rights and preferences. These transactions may provide relevant pricing information even if they do not involve the same securities underlying the share-based compensation awards. Secondary transactions, such as those involving the purchase or sale of existing equity interests between investors, employees, or third parties, offer market-based indications of fair value that reflect prices agreed upon by willing buyers and sellers.
- Entities must exercise judgment in determining the weight to place on secondary transactions and company repurchases relative to other indications of value. By carefully considering all relevant inputs and calibrating valuation models, entities can ensure that their fair value measurement of the equity securities underlying share-based compensation awards aligns with the principles in ASC 820.
- Identifying and quantifying compensatory elements in secondary transactions can be challenging. Entities need to assess whether the transaction price includes a compensatory element and how to treat the transaction in the valuation of the equity securities.
Beyond the Bottom Line
This publication highlights the importance of considering the
working draft when measuring the fair value of equity securities in share-based
compensation awards. It discusses market-based assumptions and the hierarchy of
inputs for valuation and emphasizes the need for entities to use judgment when
assessing secondary transactions and company repurchases, particularly those
involving multiple elements, such as compensatory or strategic agreements. Further,
it outlines the implications of ASC 7182 on the recognition of compensation costs for equity securities that are
repurchased from grantees in excess of fair value. It also provides decision trees
that may help entities navigate the complexities of fair value measurement and
appropriately apply the guidance in ASC 820 and ASC 718.
Background
Since the 2013 release of the AICPA Valuation Guide, the volume of secondary
transactions and share repurchases by emerging growth companies has
significantly increased. While these transactions occur in multiple industries,
they are particularly common in technology companies because such organizations
typically have equity-heavy compensation structures, which can create a demand
for the sale of shares before an initial public offering. In addition,
venture-backed technology companies attract new investors that, as part of
investing in the company, may offer liquidity to existing shareholders,
including employees.
In June 2024, as the first step in a planned comprehensive update to the 2013
edition of the AICPA Valuation Guide, FinREC released a working draft of the
following two chapters:
- Chapter 8, “Inferring Value From Transactions in a Private Company’s Securities.”
- Chapter 9, “Selected Accounting and Disclosure Matters.”
Developed by FinREC’s Equity Securities Task Force (the “Task
Force”), the working draft consolidates best practices for applying the fair
value measurement guidance in ASC 820 and the share-based compensation guidance
in ASC 718. Although nonauthoritative, the working draft provides interpretive
guidance for private companies that grant share-based compensation awards.
Connecting the Dots
At the 2024 AICPA & CIMA Conference on Current SEC
and PCAOB Developments, the FinREC chair noted that feedback during the
comment period on the working draft was relatively minor and that the
Task Force therefore does not expect to make significant additional
changes to the chapters. Accordingly, although the working draft has not
yet been finalized, entities should consider it when evaluating the
implications of secondary transactions on estimating the fair value of
their equity securities and determining whether a compensatory element
exists. The Task Force believes that companies have historically placed
less weight on secondary transactions than other indications of fair
value and that the working draft provides leading practices for an
entity’s consideration of such transactions in estimating the fair value
of equity securities underlying share-based compensation awards.
Primary Versus Secondary Transactions
It is crucial for an entity to distinguish between primary and
secondary transactions when determining the fair value of equity securities held
by private companies. Primary transactions involve the issuance of equity or
debt directly from a company to an investor, typically to raise capital or form
strategic agreements. These transactions often include preferred stock with
negotiated rights and preferences. Although primary transactions usually do not
involve the same equity securities as those granted as share-based compensation
awards, they can still provide relevant pricing information about the valuation
of the award’s underlying equity securities.
A secondary transaction involves the buying or selling of an
existing equity interest in a privately held company between investors,
employees, or third parties. Unlike primary transactions, secondary transactions
do not create new shares; instead, they transfer ownership of previously issued
equity securities. Common examples include:
- Purchases by new or existing investors.
- Tender offers.
- Private investor transactions.
- Trades facilitated through secondary exchanges.
Such transactions often serve as market-based indicators of fair
value for the equity securities underlying share-based compensation awards
because they reflect prices agreed upon by willing buyers and sellers.
Connecting the Dots
As discussed above, both primary and secondary transactions can provide
important inputs for an entity’s estimation of the fair value of
privately held company equity securities. The framework in Chapter 8 of
the working draft helps valuation specialists apply the fair value
measurement principles in ASC 820 when assessing observed
transactions.
Measurement of Share-Based Compensation Awards
Share-based compensation awards (e.g., stock options,
restricted stock units, profits interests that represent a substantive class
of equity) are classified as liabilities or equity instruments in accordance
with ASC 718. Regardless of how an award is classified, ASC 718 requires
entities to use a “fair-value-based” method to measure the award rather than
the fair value guidance in ASC 820.
A fair-value-based method excludes the effects of specific
features that (1) are sometimes included in share-based compensation awards
(e.g., contingent clawback provisions, reload features, or performance
conditions) and (2) would typically be included in a fair value measurement
under ASC 820. However, the Task Force recommends that unless ASC 820 is
inconsistent with the requirements in ASC 718, entities should apply ASC 820
to share-based compensation awards because such guidance provides a
framework for the valuation of the underlying equity security (e.g., the
equity instrument underlying the award), which is often an input into the
valuation of the share-based compensation award.
Connecting the Dots
The Task Force believes that while ASC 718 provides
guidance on performing a fair-value-based measurement, an entity
would determine the fair value of the underlying equity security
itself in accordance with the requirements in ASC 820 unless those
requirements conflict with the guidance in ASC 718.
ASC 820 Principles
ASC 820 establishes the principles for performing a market-based measurement
of fair value. ASC 820-10-05-1B states:
Fair value is a market-based
measurement, not an entity-specific measurement. For some assets and
liabilities, observable market transactions or market information might
be available. For other assets and liabilities, observable market
transactions and market information might not be available. However, the
objective of a fair value measurement in both cases is the same — to
estimate the price at which an orderly transaction to sell the asset or
to transfer the liability would take place between market participants
at the measurement date under current market conditions (that is, an
exit price at the measurement date from the perspective of a market
participant that holds the asset or owes the liability).
In addition, ASC 820 discusses the following key concepts related to the
objective of a fair value measurement:
- “Exit price” — Fair value is based on an “exit” price (i.e., the price a party receives to sell an asset or is paid to transfer a liability).
- “An orderly transaction” — Transactions that occur under normal market conditions (not in a forced liquidation or distressed sale).
- “Between market participants” — Fair value is determined on
the basis of the perspective of market participants, which include
buyers and sellers in the principal market that:
- Are independent of each other.
- Have a reasonable understanding of the asset or liability on the basis of available information obtained through usual and customary efforts.
- Can enter into the transaction and are willing to do so.
- “In the principal (or most advantageous) market” — Fair value is measured in the principal market3 even if the price in a different market is potentially more advantageous on the measurement date.4 If no principal market exists, the entity must develop a hypothetical (assumed) transaction as of the measurement date in accordance with the fair value objective in ASC 820.
- “On the measurement date” — Fair value is determined on the basis of market conditions as of the measurement date.
Because fair value measurement is a market-based measurement
based on an exit price notion, it must be determined in accordance with the
assumptions that market participants would use in pricing the asset,
liability, or equity instrument, regardless of whether those assumptions are
observable or unobservable. A measurement based on “true value,” “economic
value,” or management’s perception of value is inconsistent with a fair
value measurement. ASC 820-10-35-16B specifies that an entity should measure
the fair value of liabilities and instruments classified in equity “from the
perspective of a market participant that holds the identical item as an
asset at the measurement date.”
In addition, the fair value of liability and equity instruments should be
measured by maximizing observable inputs and minimizing unobservable
inputs.5 ASC 820-10-35-16BB prescribes the following hierarchy for such
measurement:
- Use “the quoted price in an active market for the identical item held by another party as an asset, if that price is available” (emphasis added). Otherwise, proceed to the next step.
- Use “the quoted price in a market that is not active for the identical item held by another party as an asset” if that price is available (emphasis added). Otherwise, proceed to the next step.
- Use a valuation approach to measure the fair value of the identical
item held by another party as an asset such as:
- “An income approach (for example, a present value technique that takes into account the future cash flows that a market participant would expect to receive from holding the liability or equity instrument as an asset . . .).”
- “A market approach (for example, using quoted prices for similar liabilities or instruments classified in shareholders’ equity held by other parties as assets . . .).”
Sometimes, an entity must adjust the quoted price of an
asset to properly reflect factors that do not apply to the fair value of a
liability or instrument classified in equity. As discussed in ASC
820-10-35-16D, the need for such an adjustment could arise because the
observed price is related to a similar, but not identical, asset used to
measure the fair value of a liability or equity instrument.
Principal Market
The principal market for an entity’s equity securities is the market with the
greatest volume and level of activity. ASC 820 does not require that the
principal market be organized (such as an exchange or dealer market) or
active.6 In some instances, secondary transactions may occur with an
intermediary’s assistance (e.g., a brokered market that matches buyers and
sellers but does not trade on its account). In other cases, such
transactions may be negotiated independently without an intermediary (a
principal-to-principal market). Regardless, the principal market will be the
market that has the greatest volume or level of activity that an entity can
access. An entity does not need to have access to the secondary market on
the measurement date for the market to be the principal market.
A reporting entity is not required to perform an exhaustive
search to identify all markets that could be the principal market. Unless
contradictory evidence exists, it is presumed that the market in which a
market participant normally transacts is the principal market. The concept
of the “most advantageous market” is only relevant when there is no
principal market for the equity security subject to the fair value
measurement. In such a case, an entity would need to determine the price
that would be paid or received in a “hypothetical” transaction in the
principal-to-principal market.7 The Task Force stated the following related to how companies would
make this determination:
In such a case, companies would
need to consider the likely types of market participants such as
financial investors, strategic investors, private individuals, or other
employees, that would be willing and able to negotiate independently —
and what considerations and assumptions they would make about the value
of the company’s equity securities underlying the stock-based
compensation awards, as well as what level of information they would
expect to examine in order to be willing to execute a transaction as a
knowledgeable buyer or seller, having a reasonable understanding about
the security and the transaction.
Considerations Related to Primary and Secondary Transactions
Secondary transactions for equity securities underlying share-based compensation
awards may not take place in the principal (or most advantageous market), on the
measurement date, or in an active market (which is often the case for
private-company transactions). However, companies should still consider these
transactions because they provide observable pricing information about the value
of the equity securities underlying the share-based compensation awards. ASC 820
requires entities to maximize the use of observable inputs and minimize the use
of unobservable inputs. Thus, observable transactions, even in an inactive
market, should be prioritized because they reflect actual market activity. At
the same time, unobservable information (e.g., assumptions in valuation models)
should be minimized in the determination of fair value.
Connecting the Dots
A single secondary transaction — even one that occurs on
the measurement date — may not be sufficient as an indication of fair
value. The Task Force stated:
Even when there are
observable transactions, if the market is not active, FASB ASC 820
does not require that the observed transaction price would be given
100% weight.
However, if the number of secondary transactions
increases and they are closer to the measurement date and their pricing
remains consistent, it would be less appropriate to weigh other
indications of value, including those based on primary transactions and
valuation models. This view is consistent with the principles in ASC
820, which require an entity to maximize the use of all observable
inputs and minimize the use of unobservable inputs.
In addition, while a primary transaction, such as the issuance
of newly created preferred stock, would represent an entry price rather than an
exit price under ASC 820, it can often be observable and thus provide relevant
information about the unobservable inputs to the valuation model(s) used to
estimate the fair value of the equity securities underlying the share-based
compensation award. However, primary transactions should be adjusted to properly
reflect factors that do not apply to the fair value of the equity security
(e.g., liquidation preferences and other rights), provided that any such
adjustments are consistent with a market participant’s perspective.
Lastly, while transactions between related parties (e.g.,
employees selling shares back to the company or to existing investors) are
common, an entity would not be precluded from considering them when estimating
the fair value of its equity securities. For example, ASC 820-10-30-3A(a) states
that “the price in a related party transaction may be used as an input into a
fair value measurement if the reporting entity has evidence that the transaction
was entered into at market terms.”
Framework for Evaluating Primary and Secondary Transactions
The decision tree below is based on the framework in Chapter
8 of the working draft and on the principles in ASC 820. It is intended to
help entities evaluate primary and secondary transactions when estimating
the fair value of equity securities underlying share-based compensation
awards.
The Task Force believes that most entities will navigate to
the bottom right corner of the decision tree since private-company
transactions typically occur in inactive markets. Further, the Task Force
believes that it is rare for secondary transactions to be classified as “not
orderly” since specific knowledge of transaction dynamics and an evaluation
of the indicators in ASC 820 are required for an entity to make this
determination.
Weighting Considerations Related to Secondary Transactions and Company Repurchases
While secondary transactions and company repurchases may not
be the sole basis for fair value estimates, entities must determine how much
weight to assign them relative to other indications of fair value. To
make this decision, an entity must apply significant judgment and consider
its specific circumstances.
Before evaluating the weight of a secondary transaction
relative to other indications of fair value, an entity should assess whether
the transaction involves multiple elements. ASC 820-10-35-16D requires that
an entity adjust the asset’s quote price if there are factors specific to
the asset that do not apply to the fair value measurement of the equity
instrument. This is because the objective is to measure the fair value of
the equity securities underlying the share-based compensation award, not the
fair value of a combined package that includes multiple elements. For
example:
- Transactions linked to compensation (e.g., the repurchase of shares at a favorable price to reward employees) may indicate that the transaction price does not solely reflect the fair value of the equity security. When repurchasing shares from a grantee, an entity should assess (1) whether the repurchase was based on preexisting features in the original arrangement with the grantee, such as a call feature in a stock-based compensation award, and (2) how the repurchase price was defined. As stated in Chapter 8 of the working draft, “a repurchase price based on a preexisting formula would likely not be indicative of an observable transaction price.”
- Transactions involving strategic agreements (e.g., an investor’s purchase of shares upon entering into a commercial partnership or licensing agreement) may reflect pricing influenced by other economic arrangements.
The Task Force noted that the intent to compensate may be evident:
In
some situations, it may be clear that the intent of the purchase was to
compensate the grantees (for example, a situation in which the purchase
price paid by the company was significantly in excess of the price of a
recent preferred stock financing transaction and the intent of the
company was to pay the grantees a bonus). In those situations, it may be
inappropriate to incorporate the secondary transaction in determining
the fair value of the equity securities underlying stock-based
compensation awards, as the purchase does not represent an observable
transaction reflecting solely the fair value of the equity
security.
Chapter 9 of the working draft includes the following example of how an
entity may conclude that a transaction contains a compensatory
element:
Consider Entity A, a private company, which is negotiating
with new investors (New Investors) to purchase a new series of preferred
stock in Entity A. The New Investors did not previously hold an economic
interest in Entity A. To participate in the preferred stock offering,
the New Investors must purchase a minimum number of vested Entity A
common shares held by grantees through a tender offer organized by
Entity A. Entity A specifies that only grantees that have provided
service to Entity A for more than two years are eligible to participate
in the tender offer. Through the tender offer, the New Investors acquire
1 million vested Entity A common shares held by grantees at $15.00 per
share (the same price paid per share for the new series of preferred
stock). A contemporaneous valuation of the Entity A common shares at the
time of the tender offer resulted in a fair value of $5.00 per share,
which is broadly in line with other secondary transactions that took
place in reasonable proximity to the new financing round. Because the
sale price of each share of common stock exceeds the fair value of the
common stock, Entity A considers whether the transaction is
compensatory. Entity A was significantly involved in facilitating the
tender offer and concludes that the New Investors should be considered
economic interest holders of Entity A and the difference between the
tender offer price and the fair value of the common stock represents
compensation to the grantees for prior services rendered.
In the above example, Entity A can confirm that the price of
the common shares as a result of the valuation, which was performed at the
same time as the tender offer, was generally consistent with the price
observed in other recently conducted secondary transactions. On the other
hand, the occurrence of secondary transactions in the principal market that
were more consistent with the entry price for the preferred financing (i.e.,
$15 per share) would indicate that market participants value the company on
a common-stock-equivalent basis and do not place significant value on the
liquidation preferences and other features of the primary transaction. In
that situation, an entity may view the $15 price as an observable secondary
transaction without a compensatory element. This approach is consistent with
the Task Force’s views that a market participant may not place value on the
liquidation preference in situations in which “an investor participating in
a preferred stock primary financing concurrently repurchases common stock
from grantees at the preferred stock price and there is an indication at the
time of the repurchase that market participants place value on the
liquidation preferences present in the preferred stock and no such
liquidation preferences are present in the common stock purchased from
grantees.”
However, in most instances, the analysis will not be straightforward. For
example, the Task Force stated:
[B]ecause it may not be possible for a
company to independently determine the amount of compensation expense
paid to recipients, it may be difficult to determine the stand-alone
value of the shares based upon the overall transaction price in these
types of transactions.
In addition, the Task Force observed the following:
If there is significant uncertainty regarding the
adjustments needed to the observable transaction (e.g., if the
transaction included multiple elements and the value of each element is
not clear), then it may be appropriate to give the transaction less
weight.
Thus, entities should carefully evaluate whether the
transaction price includes a multiple-element arrangement because such an
arrangement may indicate that the transaction price does not represent an
observable price for the underlying equity share. This evaluation often
involves determining whether the arrangement has a compensatory element.
When making this determination, entities should consider Tables 1 and 2
below, which are based on language adapted from the working draft and
provide indications of a transaction price that may include a compensatory
element.
Table 1:
Considerations Related to Transactions — Compensatory Elements
|
Indications That the Transaction
Price May Not Represent an Observable Price for the
Securities
|
Indications That the Transaction
Price Represents an Observable Price for the
Securities
|
|---|---|
|
|
Table 2:
Indications of Compensatory Elements
|
Indications That a Compensatory
Element Exists
|
Indications That a Compensatory
Element Does Not Exist
|
|---|---|
|
|
As noted in the above tables, one indication is related to
the entity’s treatment of the transaction for tax purposes. Stock
repurchases are generally considered to be either (1) capital (e.g., capital
gain) or (2) dividend-equivalent redemptions (e.g., ordinary dividend income
to the extent of earnings and profits). If repurchases are from current or
former service providers (i.e., current or former employees or independent
contractors), additional questions arise related to whether any proceeds
should be treated as compensation for tax purposes. In the assessment of
whether a portion of the payment is compensation, it is critical for a
nonpublic entity to calculate the appropriate value when determining the
effect of the capital redemption. That is, the nonpublic entity must decide
whether some portion of the consideration for the repurchase represents
something other than fair value for the common stock (i.e., compensation
cost). Given the complexity of making this determination, including
evaluating existing tax law, companies should consult with their tax
specialists.
In addition, Table 1 notes that the transaction price may
not represent an observable price for the securities when an entity
recognizes compensation expense for financial reporting purposes. This
interplay creates a circular dependency because the entity must consider the
transaction when estimating fair value; however, the entity cannot recognize
compensation expense without first determining the fair value of the
underlying equity security. In acknowledging this interplay, the Task Force
stated:
While chapter 8 describes this assessment
sequentially (first determining if there is a compensatory element of
the transaction and then determining whether and how that transaction
should be considered when determining the fair value of the underlying
equity security subsequent to the transaction), significant judgment is
required in assessing the interplay between whether there is a
compensatory element related to a secondary transaction and how, or if,
that transaction should be incorporated in determining the fair value of
the underlying equity security . . .
Generally, entities should first evaluate the indications of
compensation discussed in Table 2 when determining whether the transaction
includes a compensatory element. If a company concludes that a transaction
includes a compensatory element, it will need to use judgment to determine
how to weigh the transaction when calculating the fair value of the
underlying equity security.
The decision tree below illustrates how an entity would evaluate a
transaction that may be part of a multiple-element arrangement.
Table 3 below summarizes considerations related to the
weight to give transactions with multiple elements when an entity can
reasonably allocate the transaction price between the multiple elements in
the arrangements. Entities should consider the factors below, along with the
factors in Table 4, when determining how much weight to assign to the
transaction relative to other indications of fair value. The tables are
based on language adapted from the working draft.
Table 3:
Considerations Related to Transactions With Multiple Elements — Other
Elements in the Transaction
|
Indications of Less Weight (After
Consideration of Price Allocation)
|
Indications of More Weight
|
|---|---|
|
|
Weighting Considerations Related to Observable Secondary Transactions
In addition to evaluating whether a transaction involves
compensatory or other elements, an entity must determine how much weight to
place on observable secondary transactions when estimating the fair value of
equity securities underlying share-based compensation awards. The working
draft of Chapter 8 identifies several factors that may influence how an
entity would make this determination, and Table 4 below summarizes
considerations related to the weighting of observable secondary transaction
prices or adjusted transaction prices for an arrangement that has multiple
elements. Table 4 is not intended to be all-inclusive, and when considering
each factor, entities must use judgment and take into account their specific
facts and circumstances. No single factor is determinative.
Table 4:
Weighting Observable Secondary Transactions
|
Factor
|
Indications of Less Weight to Place
on Secondary Transactions
|
Indications of More Weight to Place
on Secondary Transactions
|
|---|---|---|
|
Consistency of prices
|
Transaction prices are inconsistent and do not
provide a reasonable basis for estimating fair
value.
|
Multiple transactions with consistent pricing, or
pricing that aligns with developments at the company
or in the market.
|
|
Information available
|
Buyers and sellers lack relevant information that
participants in the principal (or most advantageous)
market would consider.
|
Buyers’ and sellers’ access to information was
similar to that of participants in the principal (or
most advantageous) market.
|
|
Significance of the transaction
|
The transaction was de minimis (e.g., too small to
involve negotiations or be influenced by other
factors).
|
The transaction was substantive to both parties.
|
|
Nature of buyers
|
Buyers do not represent participants in the principal
(or most advantageous) market.
|
Buyers represent participants in the principal (or
most advantageous) market.
|
|
Timing of the transaction
|
Participants in the principal (or most advantageous)
market know that significant changes have occurred
in the company or market since the last observable
transaction.
|
The transactions were recent, with no significant
subsequent changes in the company or the markets. If
changes in the company or the market occurred
between the transaction date and the measurement
date, it is possible to calibrate to the original
transaction price and then adjust for these
changes.
|
The following are additional considerations related to
certain of the factors listed above:
-
Consistency of prices — If there have been multiple transactions as of the measurement date, consistent pricing or pricing that aligns with the company’s performance or broader market trends will indicate that more weight should be placed on the secondary transactions than on other indications of fair value. For example, a company’s recent announcement of significant milestones (e.g., product launches or new contracts) and pricing that is consistent with these announcements would suggest that greater weight should be placed on these indications. However, transaction prices that vary widely without logical explanation (e.g., unrelated to announced company developments or known market conditions) may indicate that less weight should be placed on them because the transactions may be influenced by other factors (e.g., multiple-element arrangements).
-
Information available — Buyers and sellers in secondary transactions often have access to less information than investors in primary transactions; however, this does not indicate that less weight should be given to secondary transactions relative to other indications of fair value. Instead, companies should consider the level of information that is usual and customary in the principal (or most advantageous) market. In secondary transactions, market participants may not have access to information about significant events at the company, historical or projected financial information, details about capital structures, or other nonpublic information that could significantly affect the price if it were known to the parties transacting.Connecting the DotsFor secondary transactions, access to limited (or even minimal) information may be usual and customary and therefore should not be used as a basis on which to conclude that less weight should be given to these transactions. For example, an entity should not place less weight on secondary transactions because it has nonpublic information unknown to market participants, even if that information would affect the equity securities valuation.
-
Significance of the transaction — Companies should evaluate whether the transaction was de minimis from the buyers’ and seller parties’ perspectives. Even small transactions can be substantive if they represent meaningful liquidity events for the parties transacting. Entities should be careful not to dismiss transactions or assign less weight to secondary transactions solely because they represent a small percentage of the entity’s overall equity. This is consistent with the Task Force’s views:The volume of the transaction may be considered as an indication of its relevance, but it would not be appropriate to use the volume of the transaction as a percentage of the total shares outstanding as a proxy for the percentage weight to apply. Even for securities that are traded in an active market, it is typical that only a small percentage of the outstanding shares are transacted in a given timeframe.
-
Timing of the transaction — Recent transactions are generally more reliable indications of fair value than older ones provided that there have been no significant changes in the company or market conditions since the transaction date. For example, secondary transactions conducted two weeks before the measurement date are most likely more relevant than those conducted six months earlier if significant milestones, risk, or market shifts have occurred during the interim. The point at which transactions become “stale” depends on an entity’s facts and circumstances. If changes have occurred, companies should consider whether it is possible to calibrate to the original transaction price and adjust for these changes. The adjusted transaction price would then be considered in the valuation.
Weighting Considerations Related to Other Indications of Fair Value
If the factors in Tables 3 and 4 above indicate that it is
appropriate to place less weight on secondary transactions, entities will
often use an indicator from other valuation models as one of the inputs to
estimate the fair value of their equity securities. The selected weighting
of secondary transactions and other indications of value would take into
account the relevance of the two estimates relative to each other as well as
the factors in Tables 3 and 4 above and in Table 5 below. Indicators from
valuation models often use unobservable inputs and should reflect the best
estimate of what a participant in the principal (or most advantageous)
market would use. It is important that entities appropriately calibrate
these models by using relevant observable pricing information, including
primary and secondary transactions. The Task Force stated the following
related to the importance of adjusting valuation models that appropriately
reflect market participant perspective:
[T]here may be
circumstances where certain types of valuation models or assumptions do
not appropriately reflect the extent to which market participants in the
principal (or most advantageous) market for the security underlying the
stock-based compensation award (e.g., common stock) would place value on
the liquidation preferences or other features for the securities issued
in primary transactions (e.g., preferred stock), or where the valuation
model was not appropriately calibrated to the prices observed in the
most recent primary transactions to reflect the price that market
participants in the principal (or most advantageous) market would pay
for the securities underlying the stock-based compensation awards. In
such circumstances, it would be appropriate to adjust the valuation
model to more appropriately reflect market participant perspectives
before deciding on a weighting between the indications of value inferred
from the secondary transactions and the indications of value inferred
from the primary transactions. In particular, it is important to
ensure:
- The valuation model calibrated to the primary transactions captures the extent to which market participants are considering the company on a common stock equivalent basis: for example, using a common stock equivalent method if the observable transactions indicate that market participants in the principal (or most advantageous) market assign no value to the liquidation preferences or other features, or using a debt-like preferred plus upside method or a hybrid method including a common stock equivalent scenario if market participants in the principal (or most advantageous) market would place some value on the liquidation preferences or other features.
- The valuation model is appropriately calibrated to a relevant recent transaction and captures the changes in the company and the markets between the transaction date and the measurement date . . .
Table 5 below provides considerations for weighting other
indications of fair value. The table, which is based on language adapted
from the working draft, is not intended to be all-inclusive, and when
considering each factor, entities must use judgment and take into account
their specific facts and circumstances. No single factor is
determinative.
Table 5:
Weighting Other Indications of Fair Value
|
Factor
|
Indications of Less Weight
|
Indications of More Weight
|
|---|---|---|
|
Is there a relevant recent transaction that provides
a basis for calibrating the valuation model?
|
|
|
|
What is the predictability and
confidence in unobservable inputs (e.g., cash flows,
key performance indicators)?
|
|
|
|
What is the degree of confidence in the unobservable
inputs to the valuation model?
|
|
|
Recognizing Compensation Expense
In certain situations, individuals or entities that provide
goods and services to a company or are customers of the company and hold its
equity securities may sell those securities to other investors, to unrelated
third parties, or back to the company itself. Entities should evaluate these
transactions to determine whether there is a compensatory element and, if
so, how to quantify it.
Under ASC 718-20-35-7, compensation cost must be recognized
if an entity repurchases equity securities from grantees to the extent that
the amount paid to the grantee exceeds the fair value of the equity
securities repurchased on the repurchase date. In addition, ASC 718-10-15-4
requires an entity to recognize compensation costs if an economic
interest holder8 repurchases equity securities from grantees in an amount that exceeds
the fair value of the equity securities unless the transaction “is clearly
for a purpose other than compensation.”
The Task Force observed that “it will . . . be difficult to demonstrate that
the excess paid over fair value is ‘clearly for a purpose other than
compensation for goods or services.’ ” In addition, the Task Force stated
that “a company should also apply judgment to determine whether a new
investor that purchases equity securities directly from grantees would also
be considered an economic interest holder for purposes of applying FASB ASC
718.”
In Chapter 9 of the working draft, the Task Force discussed a scenario in
which a new unrelated third party might not be viewed as an economic
interest holder:
In some cases, an unrelated third party with no existing ownership in
the entity may independently identify and negotiate the purchase of
a limited number of equity securities from an existing shareholder
with no involvement of the entity and not as part of a broader
series of transactions with the entity. Similarly, a new unrelated
third party may purchase a limited number of shares from an existing
shareholder on an established secondary exchange . . . again with no
other involvement with or by the entity. In those cases, such new
investors might not be considered to be economic interest holders
for purposes of applying the above guidance. However, as described
above, there are many instances involving the purchase of equity
securities by new investors where the task force believes it may be
appropriate to view such an investor as an economic interest holder
for purposes of evaluating the secondary transaction. . . .
When a company is involved in a secondary transaction, and such
involvement is limited to the company’s waiver of its right of first
refusal to purchase such shares, then the task force believes such
involvement by itself would not necessarily result in the secondary
transaction being viewed as within the scope of FASB ASC 718.
Thus, determining whether a new investor is viewed as an economic interest
holder under ASC 718 is primarily based on the entity’s involvement in
facilitating the transaction. The Task Force believes that a key
consideration related to making this judgment is “whether the company
(including management, such as if they are the ones negotiating with an
investor while also holding equity securities that will be purchased)
benefited from the purchase (which could include direct benefits such as
completing a concurrent primary financing round with the investor, or
indirect benefits such as improved employee morale and retention by enabling
grantees to obtain liquidity) or actively facilitated the transaction.”
[Footnote omitted]
In performing this assessment, an entity should also refer
to Table 2 above. If the entity concludes that there is a compensatory
element in the arrangement, the transaction will be within the scope of ASC
718. Further, entities will need to apply judgment to determine how much
weight to apply to the secondary market transaction when quantifying the
fair value of the underlying equity securities in calculating the amount
that is the excess paid over the fair value of the equity securities on the
transaction date.
Documentation Considerations
It is essential that companies appropriately document how they reached their
conclusions related to the considerations discussed in this publication. This
includes describing:
- How they evaluated whether a transaction includes a multi-element arrangement, such as a compensatory element, and how much weight they gave that secondary transaction relative to other indications of fair value.
- The reasons for excluding transactions that did not represent fair value or to which they gave limited weight in estimating the fair value of the equity securities underlying the share-based compensation award.
- The key judgments management applied when assessing the weight assigned to secondary transactions relative to other indications of fair value.
- The relevance and quality of the data used in each valuation method, including the data’s relevant strengths and the company’s confidence in one approach versus another.
- The completeness assessment performed to identify all potential secondary transactions that may indicate fair value.
Conclusion
The working draft of revised Chapters 8 and 9 of the AICPA Valuation Guide
provides comprehensive interpretive guidance for private companies that grant
share-based compensation awards. The Task Force believes that by understanding
the distinctions between primary and secondary transactions, applying the
principles of ASC 820, carefully evaluating the compensatory elements in
secondary transactions, and documenting their conclusions, companies can ensure
accurate and fair valuation of their equity securities.
Contacts
|
|
Aaron
Shaw
Audit & Assurance
Partner, National Office
Accounting and Reporting Services
U.S. Technology Industry
Professional Practice Director
Deloitte & Touche
LLP
+1 202 220 2122
|
|
Sean
Dineen
Advisory Principal
Deloitte & Touche
LLP
+1 212 436 5704
|
|
|
Aarti
Karande
Advisory Managing
Director
Deloitte & Touche
LLP
+1 212 436 4892
|
|
Henry
Wilson
Audit & Assurance
Senior Manager
Deloitte & Touche
LLP
+1 312 802 4897
|
Footnotes
1
FASB Accounting Standards Codification (ASC) Topic 820, Fair Value
Measurement.
2
FASB Accounting Standards Codification Topic 718,
Compensation — Stock Compensation.
3
ASC 820-10-20 defines “principal market” as
“[t]he market with the greatest volume and level of activity
for the asset or liability.”
4
See ASC 820-10-35-6.
5
The ASC master glossary defines observable inputs as “[i]nputs that
are developed using market data, such as publicly available
information about actual events or transactions, and that reflect
the assumptions that market participants would use when pricing the
asset or liability.” It defines unobservable inputs as “[i]nputs for
which market data are not available and that are developed using the
best information available about the assumptions that market
participants would use when pricing the asset or liability.”
6
The ASC master glossary defines an active market as “[a] market in
which transactions for the asset or liability take place with
sufficient frequency and volume to provide pricing information on an
ongoing basis.”
7
The ASC master glossary defines a principal-to-principal market as
“[a] market in which transactions, both originations and resales,
are negotiated independently with no intermediary. Little
information about those transactions may be made available
publicly.”
8
In accordance with the ASC master glossary
definition of an economic interest in an entity, an economic
interest holder would include any party that holds equity securities
in the entity.