Equity-based Compensation for Private Companies

stock options

ASC Topic 718, Compensation-Stock Compensation directs accounting for share-based compensation awards such as share-option awards, which are classified as either liabilities or equity. Equity-classified awards are initially measured at fair value at the grant date and are not subsequently re-measured unless they are modified and meet certain requirements. Liability-classified awards are re-measured at the end of each reporting period. If an observable market price is not available for a share-based award, the fair value of those awards is estimated using valuation techniques.

The Challenge

Determining the fair value of private company share-option awards at grant date or upon a modification to an award is often costly and complex because private company equity shares often are not actively traded and, thus, observable market prices for those shares or similar shares do not exist. When determining the grant-date fair value of those awards, a valuation technique such as an option-pricing model is typically used. Of these, the Black-Scholes-Merton model is the most commonly used model by nonpublic entities because that model is generally considered to be the least complex. Of the many inputs that this model requires, the expected term, expected share price volatility, and current share price can be costly to estimate. Alternatively, independent valuations can also be costly and time-consuming.

Solutions

In response, the Private Company Council issued ASU 2021-07 as a “practical expedient” (a more cost-effective way of achieving the same or a similar accounting or reporting objective) rather than an “accounting alternative” (a different method for recognizing or measuring a transaction or event) for private companies.

This ASU allows nonpublic companies to determine the current price input of equity-classified share-based awards issued to both employees and nonemployees using the reasonable application of a reasonable valuation method. It describes the characteristics of the reasonable application of a reasonable valuation method including:

  1. the date on which a valuation’s reasonableness is evaluated,
  2. the factors that a reasonable valuation should consider,
  3. the scope of information that a reasonable valuation should consider, and
  4.  the criteria that should be met for the use of a previously calculated value to be considered reasonable.

The same characteristics are used in the regulations related to Section 409A of the U.S. Internal Revenue Code (the “Treasury Regulations”) to describe the reasonable application of a reasonable valuation method for income tax purposes. A reasonable valuation performed in accordance with the Treasury Regulations is an example of a way to achieve the practical expedient as described in the ASU. Of course, independent valuations will still fulfill these criteria.

More details are available at the ASU and ASC Topic 718 at FASB.org. If you need assistance with reporting equity-based compensation or an independent valuation, please contact your GYF Executive at 412-338-9300.

Jeffrey A. Ford

Jeffrey A. Ford

Jeff is one of the firm's founders and is a partner in the GYF Audit and ERP Solutions Groups. He has focused his career on providing accounting, auditing and consulting services to privately held companies and not-for-profit entities. Jeff also serves as the North American Audit Practice Chair for Geneva Group International (GGI).

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