Equity-based compensation for private companies

The Challenge

Determining the fair value of private company, share-option awards at the 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 non-public entities because the 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 recognising or measuring a transaction or event) for private companies.

This ASU allows non- public companies to determine the current price input of equity- classified, share-based awards issued to both employees and non- employees 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 use of a previously calculated value to be considered reasonable. The same characteristics are used in the regulations related to Section 409A of the US 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 fulfil these criteria. More details are available at the ASU and ASC Topic 718.

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