Equity-Based Compensation and Option Valuation
FASB ASC Topic 718, Compensation – Stock Compensation, requires that the full fair value of an equity-based instrument be recorded as compensation expense. In addition, IRC §409A provides guidance on the tax treatment of equity-based instruments granted as compensation. This stock-related compensation must be valued using the most suitable methodologies, taking specific characteristics of the compensation, which is often in the form of options, into consideration.
American Appraisal develops flexible, individualized financial models to provide comprehensive and well-supported valuations for options, stock incentive units, restricted stock and other equity instruments.
Accounting for equity-based compensation presents various challenges specific to each company, its capital structure and its option types.
For closely held businesses, compliance with ASC 718 and IRC §409A may require up to three components:
Valuation of the overall equity of the business
Allocation of the total value to the various classes of equity
Valuation of the option itself (if necessary)
Many private companies, particularly those backed by venture capital or private equity investors, plan to create future liquidity for their investors through the initial public offering (IPO) process. A key valuation issue with an IPO is the fair value of equity-based securities issued as compensation in the periods prior to the IPO. The value of stock prior to an IPO is almost always less and thus “cheap” in comparison to the subsequent IPO price. However, proper documentation of stock values in the periods preceding an IPO allows companies to support the fair values of their stock.
The term “cheap stock” is applied when the strike or exercise price of an option is below the fair value of the stock at its grant date.
The valuation of pre-IPO companies is often made more challenging by:
Rapid growth rates relative to more mature publicly traded companies
Complex capital structures common in companies with venture capital and private equity investors
In 2004, the AICPA issued a Practice Aid entitled Valuation of Privately-Held-Company Equity Securities Issued as Compensation. This Practice Aid provides a framework for valuation specialists, financial statement preparers and auditors that, when appropriately applied, should yield a credible valuation that will stand up to the scrutiny of both the auditors and the SEC.
The AICPA has been updating the Practice Aid, and a working draft is available for review on the AICPA website. The updated guidance recommends that privately held companies obtain contemporaneous valuations from an independent valuation specialist to determine the fair value of the securities issued as compensation. Contemporaneous, independent valuations are especially critical for high-growth companies where valuations can increase dramatically as development or marketing milestones are reached.
A properly documented history of stock and option grants, with contemporaneous and independent valuations, will enable a company to support the fair value of its equity-based compensation.
What We Do
American Appraisal works closely with companies and their auditors to review capital structures, business plans and the terms and conditions of equity-based compensation plans to determine the fair value of share grants and options.
Our analyses are prepared in accordance with ASC 718, IRC §409A and the AICPA Practice Aid. Frequently, our analyses involve valuations of a company’s equity and an allocation of value among various classes of that company’s equity securities. We
Value the total equity of the business using appropriate methods, whether the traditional cost, market and income approaches, or unique techniques used with start-up companies.
Allocate the value of the equity to different classes, such as preferred stock and common stock, and to other instruments, such as options, warrants and convertible debt. This is typically done using option pricing models, but may require a Monte Carlo simulation.
Value discrete options and warrants, when necessary, by selecting an appropriate option pricing technique, such as the Black-Scholes-Merton model or a binomial (lattice) model, after assessing the characteristics and terms of the specific instruments.
Why American Appraisal?
American Appraisal’s independent, objective analyses have been well received by auditors, the SEC and the IRS. Our analyses comply with the FASB, AICPA and IRS guidelines on equity-based compensation. We provide comprehensive reports with results supported by thorough analyses and extensive experience.