The simplification of valuing stock compensation for private companies
In October 2021, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2021-07 (ASU 2021-07 or Update), Determining the Current Price of an Underlying Share for Equity-Classified Share-Based Awards. The ASU amends Topic 718 Stock Compensation to add a practical expedient available to companies that meet the US GAAP definition of a nonpublic entity. Determining the fair value of private company equity-classified awards can be costly for private companies especially as it relates to the current price input underlying a share-option award. To alleviate this burden, ASU 2020-07 allows for a practical expedient for a nonpublic entity to determine the current price of equity-classified share-based awards issued to both employees and nonemployees using the “reasonable application of a reasonable valuation method,” (as such term is used in ASC 718-10-30-20C, and which paragraph was added to Topic 718 by the Update). This practical expedient may be used when determining the current price of equity-classified shares, including when such price is used as an input to a valuation of an equity-classified share-option.
The practical expedient describes the characteristics of the “reasonable application of a reasonable valuation method” which are the same characteristics used in the Treasury Regulations for income tax purposes (i.e. 409A valuation). As such, a reasonable valuation performed in accordance with the Treasury Regulations is an example of a way to achieve the requirements of the practical expedient. Per ASU 2021-07, the characteristics of a reasonable valuation are listed below:
1. The date on which the valuation’s reasonableness is evaluated is the measurement date
2. The following factors should be considered in a reasonable valuation:
a. The value of the tangible and intangible assets of the entity
b. The present value of the anticipated future cash flows of the entity
c. The market value of stock or equity interests in similar entities engaged in trades or businesses substantially similar to those in which the entity electing this practical expedient is engaged
d. Recent arm’s-length transactions involving the sale or transfer of the stock or equity interests of the entity
e. Other relevant factors such as control premiums or discounts for lack of marketability
f. Whether the valuation is used for other purposes that have a material economic effect on the entity, its stockholders, or its creditors
g. The entity’s consistent use of a valuation method to determine the value of its stock or assets for other purposes
3. The scope of information to be considered in a reasonable valuation is all information material to the value of the entity
4. The following criteria must be met for the use of a previously calculated value to be considered reasonable:
a. The value is updated for any information available after the date of calculation that may materially affect the value of the entity
b. The value is calculated no more than 12 months earlier than the date for which the value is being used.
The practical expedient can be elected for equity-classified share-based awards within the scope of Topic 718. The practical expedient must be applied to all share-based awards within the scope of the practical expedient that have the same underlying share and the same measurement date (i.e., on a measurement date by measurement date basis)
When is this Update effective?
The practical expedient in this Update is effective prospectively for all qualifying awards granted or modified during fiscal years beginning after Dec. 15, 2021, and interim periods within fiscal years beginning after Dec. 2022. Early adoption is permitted for financial statements that have not yet been issued or made available for issuance as of Oct. 25, 2021.
What is the importance of the Update?
Under the guidance pre-ASU 2021-07, nonpublic entities may have obtained separate external valuations to satisfy the requirements of both Topic 718 and the Treasury Regulations which could have been costly and time consuming. Others obtained one valuation to serve various needs. The practical expedient amends certain requirements of Topic 718 to clarify that an acceptable practice is to obtain a single valuation that satisfies both requirements.
Management should consider involving valuation specialists or advisors when issuing share-based compensation and when seeking a valuation that meets both the requirements of Topic 718 and the Treasury Regulations. ASU 2021-07 provides a practical expedient for the current price input of equity-classified share-based awards but Topic 718 provides guidance on the various other assumptions and inputs to consider when determining the fair value of share-based compensation awards – those requirements have not changed.
For more information on share-based compensation, see our previous article entitled “Navigating the accounting for share-based compensation by private companies” for an overview on this topic!
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