6 Ways Equity Plan Accounting Differs for Private Companies

For the most part, ASC 718 applies equally to both public and private companies, but there are some key differences and unique challenges that private companies face. Some differences arise from the fact that private companies don’t have a market for their stock; others are practical accommodations that the FASB has made for private companies.

Fair Value Considerations

For purposes of determining the fair value of stock options (which private companies are much more likely to grant than public companies), ASC 718 provides privately held companies the same choices in option-pricing models that are available to publicly held companies. Privately held companies (and even newly public companies), however, face unique challenges in using these models.

1. Expected Volatility

Determining expected stock price volatility can be one of these challenges. Privately held (and newly public) companies do not have sufficient, or any, trading history on which to base their expectations of stock price volatility. Thus, privately held companies typically use the expected volatility of similar publicly held companies. Most private companies look to the same group of peer companies that are identified for purposes of their 409A valuation.

2. Expected Term of Stock Options

Private companies typically find it challenging to develop an appropriate expected term assumption when valuing stock options, again due to lack of historical activity. ASC 718 offers a practical expedient that private companies can use to calculate expected term for options that meet the following conditions:

• The option has an exercise price equal to the fair market value on the grant date.
• The employee has only a limited time in which to exercise after termination of employment (typically only 30 to 90 days).
• The employee cannot sell or hedge the option.
• The option does not include a market condition.

For options and SARs subject to service-based vesting, the practical expedient is midway between the vesting period and the contractual term of the grant. For example, if an option is subject to four-year cliff vesting and a contractual term of ten years, the company could assume an expected term of seven years.

3. Fair Market Value of Underlying Stock

Because their stock is not actively traded, private companies typically find it challenging to establish the fair market value of their stock. This is a critical input necessary to establish the fair value of all types of equity instruments. Here again, ASC 718 offers a practical expedient that private companies can use to determine the fair market value of their stock when valuing awards that receive equity treatment.

The practical expedient allows private companies to “use a value determined by the reasonable application of a reasonable valuation method.” A Section 409A valuation is an example of a reasonable valuation, provided it meets the following conditions:

• The valuation considers factors that the standard deems necessary to ensure reasonability. These might include the value of the company’s assets and future cash flows, the market value of stock of similar companies, or recent sales of the company’s stock.

• The valuation takes into consideration all the available information material to the value of the company.
• The valuation does not reflect information available after the date of the calculation that may materially affect the company’s value.
• The value was calculated no more than 12 months before the date for which the valuation is being used (i.e., the award grant date).

4. Early Exercise Provisions

Private companies sometimes grant options that include an “early exercise” provision, under which the optionee is permitted to exercise the option before vesting. Shares that are purchased before vesting are nontransferable until vested and, if the optionee terminates before vesting, are subject to repurchase at cost. This arrangement can offer tax advantages for the option holder. See the NASPP blog entry “Stock Option Early Exercises: Accounting Considerations” to learn how this feature affects the accounting treatment of the awards.

5. IPO-Contingent Vesting Conditions

Another somewhat common practice among privately held companies is to grant options or awards in which vesting is contingent on the company’s IPO (or acquisition by another company). Oftentimes, the awards are subject to both service-based vesting conditions in addition to the IPO/CIC vesting requirement. The period over which the service-based conditions are achieved often differs from the period in which the IPO/CIC must be achieved. The service-based conditions are often fulfilled over the three- or four-year period following grant, whereas the grants might allow for up to ten years for the IPO/CIC to be achieved. (This differs from more traditional performance awards in which vesting is contingent on operational or market conditions and in which the service and performance conditions are typically fulfilled over the same time period.)

As is the case for other types of awards that are subject to non-market performance conditions, expense should be recorded only to the extent that the performance condition (i.e., an IPO or CIC) is likely to be achieved. But, unlike other operational metrics, when the performance metric that vesting is contingent on is an IPO or CIC, the FASB has indicated that the likelihood of the condition being achieved is 0% until the IPO or CIC is a certainty.

Thus, where vesting in options or awards is conditioned on an IPO or CIC, companies typically don’t record any expense for the grants until just before the IPO or CIC, at which point they suddenly have to recognize a lot of expense all at once.

For example, assume a private company grants an award with an aggregate grant date fair value of $400,000; vesting in the award is contingent upon both an IPO and the award holder completing four years of service. Because of the IPO contingency, the company initially won’t record any expense for the award. Let’s say that the company goes public three years after the award is granted.  In the period of the IPO, the company will record $300,000 of expense for the award, which is the expense attributable to the three year’s of service that have been completed. The remaining $100,000 of expense will be recorded over the next year in which the remaining service is completed. (This example assumes that the company accounts for service-based forfeitures as they occur.)

6. Liability Awards

Unlike their public company counterparts, private companies can elect to account for awards that are subject to liability treatment at either their fair value or intrinsic value. Companies may find that relying on the intrinsic value method significantly reduces the administrative burden of accounting for liability awards.

Regardless of which method is elected, expense for the awards is estimated and adjusted based on current conditions at the end of each fiscal period until settlement occurs under the award. Upon settlement, a final adjustment is recorded to true up the most recent estimate to actual outcome.

The decision to account for liability awards at either fair value or intrinsic value is an accounting policy election. As such, it should be applied to all liability awards issued by the company, including awards issued to both employees and nonemployees. A change in election is considered a change in accounting policy, requiring a preferability letter from the company’s auditors and retrospective application to the company’s financials.

Learn More

Check out the NASPP course “Equity Compensation Fundamentals – Private Companies” to learn more about accounting for equity compensation, as well as other concepts important to managing equity programs in private companies.