Private Company Update: Valuation and Compensation Implications of Private Transactions

*Josh Schaeffer is a member of the AICPA’s Financial Instruments Advisory Group. The opinions in this article are his own and do not reflect those of the AICPA or the Advisory Group.

On June 23, the AICPA’s Financial Reporting Executive Committee (FinREC) released a working draft of two revised chapters from its practice aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation.[1] The draft guidance, which addresses private stock transactions, coincides with a significant uptick in the number of marketplaces available for such transactions. Employees today can sell private company stock to the company through buybacks, within transactions facilitated by the company, or through newly developed private marketplaces.

The newly revised chapters have two areas of focus. Chapter 8 provides guidance on using transactions to infer the price of a subject security, while Chapter 9 discusses security purchases from employees from a compensatory standpoint through the lens of ASC 718. As in the past, the guide isn’t intended to create any new accounting or valuation rules. Instead, the aim is to collect best practices and provide references for practitioners.

Guidance in Chapter 8

Does it make sense to use transactions to infer a fair value of private company shares? Yes, if there’s a large arm’s-length transaction or an active principal market in an identical security as of the buyback date. The reason is that these values closely represent fair value.

However, most transactions—including deals with existing shareholders, buybacks, sales of other company securities, components of larger transactions, facilitated purchases, tender offers, and private secondary markets—are not so analogous. Chapter 8 aims to address how one should view those sorts of data points in appraising value. Specifically, it focuses on cases where:

• The transaction may be in an environment which does not assure the best price for the subject security
• The transacted security may not have the same economic features as the subject security
• The timing of the transaction may be too old relative to the measurement date

If any of these is true, practitioners should consider reducing the weighting of the transaction in their valuation estimates, adjusting to control for the differences, or even discarding the transaction entirely.

Was the transaction for a price reflective of the subject security’s fair value?

The goal of this guidance is to establish that the transaction gives a reliable estimate of the fair value of the security.[2] Factors such as the following can indicate that the transaction may be reflective of fair value.

• The transaction was between the company and a new investor
• An active market exists for the security rather than a single transaction, or there are multiple transactions at the same or similar prices
• The parties acted at arm’s length in a negotiation, with proper due diligence

On the other hand, in the following situations, the price may not be reflective of fair value.

• The transaction was undertaken as part of a broader agreement or deal, or between existing shareholders and the company
• The transaction was part of a fire sale or other distressed scenario[3]
• The transaction occurred significantly before the valuation date, or there had been material changes to the enterprise between the transaction and valuation dates
• The transaction was for a de minimis amount

If any of these apply, it’s appropriate to lower the weighting of the transaction relative to market and income approach valuations.

It’s easiest to think about a few common examples:

A company sells common stock to investors. If all the investors already have a significant amount of preferred stock, this may not accurately reflect fair value. However, if a new investor accounts for half of the purchases, the transaction is likely to reflect fair value.

A company sells $10,000 of stock to the founder’s parents. In this case, the amount of money exchanged is fairly small, and the founder may have interest in a discount here. This transaction would likely be ignored.

A company’s private stock traded daily on a secondary market exchange where both employee and non-employee buyers frequently traded with minimal transaction costs. In this scenario, the current trading prices would likely be considered usable for valuation purposes. Alternatively, if the exchange had closed three months ago after such trading activity had occurred, the price might need adjustment to account for developments subsequent to the closure.

Does the security in the transaction match that in the valuation?

Here, the goal is to confirm that the transaction is in the same security. For example, a company may be valuing common stock for restricted stock grants based on the common stock price during the latest round of preferred issuance. Employees are often granted common stock, which lacks the liquidation preference and other key features of preferred stock. In that case, rather than simply equating, say, preferred stock to the price of common stock directly, the waterfall approach of the option pricing methodology may be used to infer the value of the common stock, with an appropriate haircut for the discount for lack of marketability.

In addition to the often-seen common and preferred stock scenario, here are some others where the transaction may need to be adjusted.

• If a transaction is part of a portfolio where both common and preferred stock are bought, or warrants are issued as a sweetener, nominal prices may not properly reflect the fair values of each security. In order to adjust this, an allocation should be done to distribute value between the various components

• If a transaction is in connection with a broader agreement between companies, this may factor into the value. For example, if a supplier buys 1 million shares of common stock for $10 each, but also enters into an exclusive supply agreement, the price for common stock may be overstated to reflect the value of the agreement

• If the company swaps its equity securities for other assets or securities without readily determinable fair value (for example, common stock in another private company or real estate of the same value), the stated price may not be reflective of fair value. In this case, it’s useful to perform a fair value analysis on either one or both sides of the transaction. On the other hand, if the swap is for publicly traded common stock or debt, or even a liquid security like bitcoin, it’s reasonable to use the dollar price

• If the transaction reflects a controlling stake of the company, this may not be applicable for a small number of employee shares. In this case, an adjustment for control and/or marketability may apply

In all of these cases, adjustments can be made to account for the different circumstances of these transactions. As a result, careful attention can be paid in comparing and adjusting any transaction that isn’t identical to the subject security.

We note that these adjustments are ones we’ve routinely put into place when we see these transactions. They’re consistent with the ASC 820 definition, which in part focuses on quoted prices of similar securities as Level 2 inputs. Also, if a transaction consists of multiple components such as our exclusive supply arrangement, bifurcations may even be required under other GAAP pronouncements.

Guidance in Chapter 9

Chapter 8 focuses on including and weighting transactions in valuation under different criteria. In contrast, Chapter 9 is about compensatory aspects of transactions and related disclosure requirements.

Under ASC 718, if a company purchases a security from an employee for more than fair value, this needs to be recorded as compensation. Chapter 9 extends this consideration to a secondary transaction that is facilitated by the company. For example, the company may enable a tender offer in which employees sell shares to an outside investor at a price above the security’s fair value, or otherwise adds additional rights such as a liquidation preference to the shares. Either of these would be considered compensatory in the amount between the transaction price and the fair value of the employee’s underlying stock, as developed through a valuation.[4],[5]

When evaluating the transaction, it’s important to focus on intent. In some cases, the transaction is clearly to provide liquidity, e.g., selling additional shares of the same security in a later round of financing. Others are more directly compensatory in nature. Some indicators are:

• The company or investor agreed (via phone, email, or other communication) to compensate the grantees

• The company determined the purchase price or directly negotiated the purchase price with the investor without any negotiation between the investor and grantees. In this instance, the company is more likely to benefit from setting its own price than if the price had been negotiated between buyer and seller[6]

• The company determined a narrow set of parameters for the investor purchase (e.g., which grantees could participate in the secondary transaction and the extent to which those grantees could sell their equity instruments). As an example, the company could establish a price available to some, but not all, market participants. This would beg the question as to why these grantees should get special treatment

• The company has a history of repurchasing securities from employees at higher than market value

The remaining discussion centers on disclosure requirements. Much of it is reproduced from applicable sections of ASC 718 (like ASC 718-10-50-1) to state that a company should fully disclose the nature, impact, and valuation assumptions of any compensatory transactions. There’s also some commentary about Management Discussion and Analysis (MD&A) disclosures in an IPO. Specifically:

• Entities that file for an IPO should consider disclosing the methods used to determine the fair value of the equity securities in stock-based compensation

• Entities that file for an IPO should consider how other MD&A requirements may be related to stock-based compensation

• If the estimated fair value of the equity securities is substantially below the IPO price (i.e., cheap stock), then registrants should reconcile the change in the estimated fair value of the underlying equity securities between the grant date of the award and the expected offering price

Once again, there’s nothing new here. ASC 718 already requires the expense for compensatory purchases, and while they’re infrequent, we’re sometimes asked to assess the value and recognize their expense. Further, a keen eye is needed to understand whether these transactions are compensatory or simply providing liquidity. Still, it’s useful to have these examples and more concrete disclosure requirements to deal with these transactions.

Our Take

While most of this may seem old hat to seasoned valuation professionals, it’s important to note that characteristics of secondary transactions weren’t well codified under the current practice aid. By contrast, ASC 820-10-35-541(I) through 35-541(J) has clear language around the identification of orderly transactions and what to consider in the case of forced transactions (like a liquidation or distress sale), placing less weight on them than other measures of value.

In short, the addition of these two chapters will help to improve the existing AICPA guide in line with best practices. In addition, we believe the new guidance provides a good framework as private company transactions become increasingly common, more and more without full visibility of the company itself.

The AICPA is looking for feedback on the draft chapters by September 20, with the fully updated practice aid likely to be finalized sometime next year. We’ll keep readers apprised of any new developments.

[1] Most users in the valuation community simply abbreviate this title as the “Cheap Stock Guide” due to its usage in analyses related to Internal Revenue Code §409A regarding option granting strike prices.

[2] The draft notes the similarity of ASC 820 and ASC 718 definitions of fair value and IRS Revenue Ruling 59-60 definition of fair market value for purposes of this exercise. All consider some concept of a willing buyer and willing seller, both arriving at a value through the consideration of all available facts.

[3] A forced transaction isn’t “orderly,” i.e., there was too little exposure to the market for a period before the measurement date to allow for marketing activities.

[4] In some cases, the transaction may involve other aspects, such as settling an existing obligation.

[5] Note that there is a significant interplay between Chapters 8 and 9. For example, if a buyer did their due diligence, negotiated with the company, and purchased shares from both the company and some shareholders, it is likely that the investment was at fair value, and thus not compensatory.

[6] Note that this statement is true even in non-compensatory situations.