Measuring Equity-Based Awards’ Fair Value

Stock options and other forms of equity-based compensation are often awarded by cash-strapped start-ups and high growth firms to attract and retain skilled employees. These rewards can also provide incentives to boost performance and add value. However, there’s a downside: accounting for these payments can be costly and complicated, particularly for private businesses.

Below is an overview of existing guidance under U.S. generally accepted accounting principles (GAAP), and with a possible expedient that’s on the Private Company Council’s (PCC) upcoming agenda.

Equity-Based Awards

Employee stock options are generally expensed as they vest at their fair value on the grant date, rather than the exercise date under existing GAAP. A deferred compensation liability is also recorded on the balance sheet. To complicate matters further, they may also be subject to Internal Revenue Code (IRC) Section 409A, which means the potential for deferred tax items.

Companies generally consider six inputs when measuring the fair value of equity-based awards:

1. Exercise price
2. Expected term (time until expiration)
3. The risk-free rate (usually based on Treasury bonds)
4. Expected dividends
5. Expected stock price volatility
6. The fair value of the company’s stock on the grant date

The first four inputs are fairly straightforward. Using a comparable market-pricing index, private companies may estimate expected stock price volatility. But the fair value of a private company usually requires an outside appraisal, whereas public stock prices are often readily available.

Possible Relief

To advise the FASB on private company matters, the PCC will meet in mid-December and discuss a practical expedient for private companies that offer equity-based compensation. A practical expedient is a more cost-effective way to achieve the same, or a similar accounting or reporting objective. The PCC is considering a proposal that would provide private companies with a simpler, more cost-effective way to measure the grant-date fair value of equity-based awards.

Specifically, an accounting exception would align the measurement philosophy for determining the underlying share price with the measurement philosophy articulated in IRC Sec. 409A; this eliminates the need for private companies to perform two separate valuations by tying the exposure document language directly to Sec. 409A.

Equity-based compensation awards often depend on the company stage and employee level. Issuing restricted stock and management incentive units, rather than traditional stock options, has become a trend among companies. A Sec. 409A compliant valuation isn’t too costly to obtain, and companies often rely on this valuation to determine current price.

Russell Golden, FASB Chairman, said a Sec. 409A alignment would make more sense than prior suggestions: “To me it would be a lot simpler, a lot more understandable if you tied the measurement philosophy of the underlying stock with what’s in 409A and not this use that says ‘this is what management says it is unless you find evidence that it is not.’”

However, not every company obtains a Sec. 409A complaint valuation. The number of private companies likely to adopt the practical expedient could be limited.

More to Come

Some companies have shied away from issuing equity-based compensation awards because of financial reporting complexity and outside appraisal cost. However, book-to-tax conformity may soon provide relief. For the latest developments on this issue or with help complying with the current guidance on report equity-based payments, contact a Weaver professional.

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