Private Company Relief Proposed for Share-Based Payments
Private companies have struggled with the cost and complexity of determining the fair value of stock-option awards when granted or modified, primarily because their equity shares often are not actively traded and observable market prices for those shares or similar shares do not exist. Under current accounting guidance in Accounting Standards Codification (ASC) 718, Compensation—Stock Compensation, if an observable price is not available, companies must use a valuation technique such as an option-pricing model to determine the grant-date fair value of awards. These models require various inputs, including the fair value of the equity shares underlying a share-option award (referred to as the current price input). The current price input is typically the most difficult input for private companies to estimate and substantiate to auditors, primarily because of the lack of observable prices. ASC 718 already provides private companies with a practical expedient to estimate other option model inputs for expected share price volatility and term.
On August 17, 2020, FASB issued a proposal that would create a practical expedient on an award-by-award basis for private companies to leverage valuations already used for tax purposes under Section 409A of the Internal Revenue Code to estimate the current price input to determine the fair value of an equity-classified share-option award granted to employees and nonemployees. The practical expedient would not be available for liability-classified awards.
Comments are due by October 1, 2020. The effective date will be determined after feedback is evaluated.
Section 409A Valuations
Section 409A regulates taxation of nonqualified deferred compensation and applies to many share-based compensation arrangements. Treasury regulations include the acceptable valuation procedures for awards subject to §409A. To avoid significant penalties under §409A, the exercise price of a share-option award should be set at or above the fair market value of the underlying share as of the grant date. Section 409A states that an entity with stock that “is not readily tradable on an established securities market” may avoid being subject to §409A by obtaining or performing a valuation based on the “reasonable application of a reasonable valuation method.” Under §409A, an entity may demonstrate to the IRS that the fair value of a share underlying a share-option award was determined using a reasonable application of a valuation method by:
- Considering certain facts and circumstances as of the valuation date, or
- Meeting a rebuttable presumption of reasonableness
FASB concluded that only valuation methods meeting the rebuttable presumption of reasonableness would be allowable under this proposal for a practical expedient. The following methods are acceptable under the rebuttable presumption of reasonableness requirements of §409A to determine the fair market value of a share:
- A valuation determined by an independent appraisal within the 12 months preceding the grant date
- A valuation based on a formula that, if used as part of a nonlapse restriction with respect to the share, would be considered the fair market value of the share
- A valuation made reasonably and in good faith and evidenced by a written report that considers the relevant factors of the illiquid stock of a startup corporation
Nonpublic entities most commonly use an independent appraisal to meet the rebuttable presumption of reasonableness of §409A for tax purposes. Because the other methods are subject to restrictions, they are used much less frequently.
A private company that already obtains §409A compliant valuations for tax purposes may save time and money in valuing stock compensation for generally accepted accounting principles financial statements under this practical expedient.
BKD will continue to follow this project. If you have questions about these changes, contact your BKD Trusted Advisor™ today.