Equity Compensation (ASC 718, ASC 505)
Oftentimes, venture-backed startup firms or privately held companies issue equity compensation to employees, incentivizing them to grow company value with the same vigor as a founder, investor or owner of the company.
Compensation issued in the form of equity requires accounting treatment outlined in ASC 718 and ASC 505. ASC 718 governs equity issued to employees while ASC 505 governs equity issued to non-employees. On a high level, when equity issued is in the form of compensation, the company must expense the grant date fair value of the compensation through the income statement. The compensation expense may be amortized over a period of time which is dependent on the characteristics of grant (for example, an employee granted profit interests with a service period requirement allowing 25% of the issued equity to vest each anniversary would generally be amortized over the vesting period).
Completing an equity compensation analysis may require a business enterprise valuation of the company. Typical approaches utilized include the income approach, market approach or the cost approach. After calculating a business enterprise valuation, one can determine the aggregate equity of the company allowing for the valuation of individual equity securities in the capital structure.
The underlying capital structure determines the models used to determine the fair value of the equity compensation. A simple capital structure with only one class of equity (e.g. common stock) could simply require using a Black-Scholes option pricing model. On the other hand, a capital structure with multiple series of preferred securities, common stock derivatives, and incentive compensation securities with various market performance vesting requirements will likely require a more sophisticated option-pricing model (e.g. the option-pricing method (“OPM”) or Monte Carlo simulation analysis).
VRC has valued various forms of equity-based compensation including stock options, profit interests, employee share purchase plans, restricted stock awards, phantom stock, and stock appreciation rights to name a few. Our reports include a supportable and auditable analysis for financial reporting requirements under ASC 718 and ASC 505.
Gifting carried interests to the next generation of family members is a common estate planning strategy for general partners of venture capital, private equity, real estate investment and hedge fund management companies.
A well-structured valuation analysis and report must satisfy IRS Adequate Disclosure requirements to limit the IRS’ look-back period to three years from the date the transfer tax return is filed, which is often several years before returns are realized for partnerships with investment strategies that require five or more years.
VRC professionals have the depth of expertise to deliver clients with a thorough analysis that relies upon reasonable assumptions, valuation approaches and methodologies, and a result. To capture the asymmetric nature of the carried interest, we rely on multiple scenarios reflecting a range of future return expectations when using an income approach. Other forward-looking valuation methodologies include Monte Carlo Simulations, which can address multiple areas of uncertainty (timing of exits, returns expectations, funds deployed, etc.), and other risk-neutral or option pricing-based methodologies. Other critical components of a thorough analysis include the development of appropriate discount rates and a supportable discount for lack of marketability that give consideration to the methodologies we rely on.
Private companies at all stages of development should obtain periodic independent valuations of their common stock to support equity incentive grants in a timely manner. By granting awards that do not have immediate intrinsic value, no income is perceived at the grant date that would trigger a tax liability under IRC Section 409A.
The “Valuation of Privately Held Company Equity Securities Issued as Compensation” issued by the American Institute of Certified Public Accountants (AICPA) (updated in 2013) serves as the standard for best practices. Complex capital structures and the outlook for a future liquidity event are captured in a common stock valuation using either an estimate of the total equity value or a recent transaction in the company’s equity capital.
VRC professionals work with valuation methods that give consideration to the entire capital base using option-pricing techniques that consider economic rights including preferences, seniority, convertibility and dilution of all residual and contingent claim equity classes.
Stock Option Plans (ASC 718)
Accounting Standards Codification 718 (ASC 718) requires that the cost resulting from all share-based compensation be recognized in the financial statements. The fair value is estimated at the time of grant using a methodology and inputs appropriate to the form of the award.
VRC values all forms of share-based awards involving stock option and restricted stock grants, as well as LLC incentive units or profits interests. Our valuation professionals work with option pricing models and more advanced numerical methods to capture the specific vesting features and pay-off opportunity.
Cheap Stock Valuation
Cheap stock refers to the issuance of an equity security (e.g. options, warrants, common stock or restricted stock), during the 12 months preceding an IPO for a price (or with a strike price) that is below the expected IPO price. Typically, this issue arises in connection with the granting of employee stock options. To avoid a cheap stock charge, it is important to support each option grant by obtaining a contemporaneous valuation from an independent valuation specialist.
We provide valuations of cheap stock in accordance with the allocation methods outlined in the “Valuation of Privately Held Company Equity Securities Issued as Compensation” issued by the American Institute of Certified Public Accountants (AICPA) (updated in 2013), which serves as the standard for best practices.