ASU 2021-07-A Practical Expedient to Aid in the Valuation of Underlying Shares of Equity-Classified Share-Based Awards
Stock compensation awards in nonpublic companies, such as stock options, are often used to help motivate executives and employees alike to improve performance, as the employees have a personal stake in the success of the company. Providing employees with equity shares in the company, as opposed to a cash payout, is useful for companies such as start-ups, which may not have cash as readily available. However, although it can be a great motivator, it can be challenging regarding the valuation of this compensation.
FASB ASC Topic 718, “Compensation – Stock Compensation,” has addressed how to valuate these compensation awards in nonpublic companies by using option pricing models, such as the Black-Scholes model. While these methods may be a good estimate of the value of these awards, it is often complex and expensive for companies due to inputs in the models that are difficult to value. This includes the fair value of the stocks, as they are not publicly traded.
To help make this easier, the FASB has issued a practical expedient under ASU 2021-07 “Determining the Current Price of an Underlying Share for Equity-Classified Share-Based Awards.” The practical expedient allows the “reasonable application of a reasonable valuation method” to value the price of shares, which has been the pain point in the option pricing models. As the “reasonable application of a reasonable valuation method” may appear vague, ASU 2021-07 has given guidance on what characteristics that may include during the valuation. Those characteristics are summarized below:
- The value of the tangible and intangible assets.
- The present value of the expected cash flows.
- The market value of stock or equity interests in similar companies.
- Arm’s-length transactions in the sale of the stock or equity.
- Other factors of stock including the control premiums or discounts due to marketability.
- The valuation methods used for other stocks or assets in the company.
The amendments recognize that a valuation performed in accordance with Treasury Regulation §1.409A-1(b)(5)(iv)(B) would be a “reasonable application of a reasonable valuation method.” It is important to note that the valuation will need to be performed for each reporting period. Although it has been difficult to value the stock compensation awards, applying the characteristics found in the practical expedient in ASU 2021-07 to value underlying stock, should make that process easier.
If you have any questions or would like to discuss your financial situation, please do not hesitate to reach out to your WG advisor or e-mail us at [email protected].