Fair Value Guide for Private Company Equity Awards

Equity compensation in private companies is found in private equity, venture capital, employee ownership plans, and closely held businesses. Private companies use equity compensation to attract, retain, and reward employees. It can also support ownership transition and serve as a key component in growth strategies and value creation. For example, a private equity firm may issue profits interests to key employees, while a venture-backed company might offer stock options through a broader program. An Employee Stock Ownership Plan (ESOP) could provide equity to all qualified employees as part of a retirement plan under the Employee Retirement Income Security Act of 1974 (ERISA).

Private companies can issue many types of equity compensation, including phantom shares, appreciation rights, options, restricted units, profits interests, and performance shares. These can be customized to meet diverse objectives. The types used depend on company culture, industry practices, and shareholder goals.

Understanding the Standard of Fair Value for Equity Compensation A valuation of equity compensation is required for the grant date to comply with financial reporting standards in the United States for Generally Accepted Accounting Practices (GAAP) under Accounting Standards Codification (ASC) 718 and in other countries for International Financial Reporting Standards (IFRS) 2. Under these accounting guidelines, equity compensation is referred to as share-based payments and is reported under the standard of fair value.

ASC 718, fair value is defined as:

“The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.”  

IFRS 2, fair value is defined as:

“The amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm’s length transaction.”

Although defined differently, these standards are generally considered to be equivalent. These definitions of fair value basically follow the concept of establishing what the particular equity compensation unit would hypothetically sell (trade) for in the market. This is for the unit itself, separately, and not as part of a sale of the company. The fair value standard presumes such a transaction can take place, even though shareholder agreements may have restrictions or a market for such private company shares may not actually exist.

Valuations also support tax compliance, transactions, regulatory, and other needs. Examples include:

• Venture capital: Price stock options and comply with IRC Section 409A safe harbor provisions.
• Private equity: Establish tax safe harbor thresholds for profits interests under IRS Revenue Procedures 93-27 and 2001-43.
• ESOPs: Satisfy ERISA valuation and reporting requirements.
• Communication: Keep plan participants and stakeholders up to date.

Valuation Requirements for Private Companies All this means a private company must have a valuation as of the grant date to support financial reporting requirements for equity compensation. But unlike public companies, private companies lack a readily available market price to use for this purpose. A private company must have a valuation analysis performed. However, doing a valuation for every grant date in a private company is often impractical.

Fortunately, private companies can take advantage of a general guideline for financial reporting referred to as the one-year rule. This allows a valuation as of a given date to be used for grants over the following 12 months, provided no material changes occur during that period that could impact the value. For example, a valuation as of December 31 could be used for grants in the next year, but not retroactively to prior grants. This is because fair value standards view that while value at December 31 would be known at future grants, it could not be known at earlier grants since it is subsequent knowledge. However, if the company made an acquisition or raised new funding, the valuation would need to get updated, even if it had been less than a year.

The Three-Step Process to Determine Fair Value of Equity Compensation in Private Companies

A three-step process is considered best practices for private company valuation of equity compensation. This approach follows guidance issued by the American Institute of Certified Public Accountants (AICPA) in two key Accounting and Valuation Guides:

• Valuation of Privately-held Company Equity Securities Issued as Compensation (Cheap Stock Guide)
• Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (PE/VC Guide)

It also conforms to AICPA guidance in its Statement of Standards for Valuation Services No.1 (SSVS-1) and GAAP in VS 100, as well as general business valuation standards and best practices.

Step One: Determine Business Enterprise Value (BEV) and Total Equity Value (TEV)

The first step is to develop a BEV as of the grant date. BEV represents the hypothetical sale price of the business with market participant assumptions under the ASC 820 fair value standard. BEV should reflect current operations under existing ownership and exclude assumptions about future acquisitions, synergies, funding rounds, or IPO pricing.

Common valuation methods to estimate BEV include:

• Discounted Cash Flow (DCF): Uses projected future cash flows of the company and discounts those to present value with an expected rate of return.
• Market Multiples: Obtains financial metrics such as earnings before interest, taxes depreciation, and amortization (EBITDA) or other financial measures. These are compared to the BEV in a group of similar public companies and the metrics are applied to the private company.
• Market Transactions: Similarly to the market multiples method, this benchmarks financial metrics in recent merger and acquisition transactions for similar companies and applies those to the private company.
• Asset Approach: Typically used for holding companies, where the BEV is the total value of all the various assets and investments.

The method used depends on the availability of information, business factors, and judgement. Because private company valuations are inherently subjective, using multiple methods can help strengthen conclusions.

After establishing BEV, Total Equity Value (TEV) is generally calculated as:

TEV = BEV + Cash − Debt (Net Debt)

For example, if BEV is $100 million and net debt is $40 million, TEV equals $60 million. Other liabilities, such as earnouts, may also be considered. Conceptually, TEV in a private company is comparable to the market capitalization in a publicly traded company.

If there have been recent investment transactions in a private company, such as a private equity acquisition or a venture capital funding round, those may provide a basis to establish BEV and/or TEV. This often provides a strong basis for value without the need to use other valuation methods, particularly when the transaction is independent and arms-length between the company and investors. If there are offers or perhaps an IPO in the near future, these can potentially provide an additional basis for BEV.

The goal of Step One is to establish TEV, estimating the proceeds from a hypothetical sale of the company that would be available for distribution to all equity interests.

Step Two: Allocate Total Equity Value Across All Equity Interests

Next, TEV must be allocated across all equity interests in the company. Private companies that issue equity compensation will often have multiple classes of equity, including common shares, other equity compensation units, preferred shares, warrants, or convertible debt.

When a privately owned company has more than one class of equity, it is defined as a complex capital structure. Complex capital structures have what are referred to as waterfall provisions in shareholder agreements. Waterfall provisions define the order, amounts, and participation in distributions for all equity interests. For example, where preferred shares receive capital and dividends before payments go to other interests.

Typically, when management or investors in a private company apply a waterfall to TEV, it is based on a simple approach. This is to take the TEV and run it through the waterfall, with payouts to the various interests based on features and rights at that time. The resulting payouts are used as the value of each equity interest. This is referred to as a cash-based, intrinsic value, or current value method.

However, when there is a complex capital structure, financial reporting for equity-based compensation in a private company requires the use of option-based valuation methods. This is because the standard of fair value requires consideration of the potential for future changes in value that is implicit in these financial interests. That perspective also captures the incentive features inherent in equity compensation plans.

Where publicly traded companies most often use the Black Scholes equation to value equity compensation such as stock options, private companies with complex capital structures commonly use other option-based methods:

• Scenario Based Method (SBM): Uses simple estimates of future BEV and TEV under a number of scenarios, applies a waterfall, then discounts a weighted average to present value.
• Option Pricing Method (OPM) Backsolve: This method applies concepts in the Black Scholes equation to complex capital structures using projected waterfalls and risk.
• Monte Carlo Simulation (Monte Carlo): Similar to an SBM, however it uses an algorithm that incorporates risk to forecast future BEV or TEV, waterfall, and potential payouts, discounted to present value.

These more advanced option-based methods are rarely used by management or investors and typically require hiring outside valuation professionals due to the complexity and customization involved.

The result of Step Two is a preliminary value for the equity compensation units before some final adjustments.

Step Three: Apply Final Adjustments to Determine Fair Value

The final step considers additional factors required under ASC 718 and IFRS 2 to get to fair value.

These adjustments should only be applied at the equity compensation unit level and not to BEV or TEV.

Examples of typical adjustments in private companies include:

• Vesting conditions
• Voting rights or lack thereof
• Transfer restrictions
• Non-controlling ownership (less than 50 percent)
• Lack of marketability (liquidity)
• Put and call rights or redemption features

The most frequent adjustment for equity compensation in a private company is a discount for lack of marketability. This reflects the absence of a ready market for private company equity interests to get liquidity. This contrasts to a publicly traded company where equity compensation units can often convert to cash in a short period of time.

This discount depends on factors such as time to liquidity, risk of value changes, and waterfall provisions. This adjustment is most often developed for equity compensation using quantitative methods, published data sources, or benchmarks.

When outside professionals assist management on the valuation analysis, these adjustments are normally incorporated into the scope of work.

Step Three concludes with preparing expense schedules, journal entries and information for footnote disclosures.

Final Points

The valuation analysis described above is only required for financial reporting when the company is granting equity compensation. If there are no grants in a reporting period, a valuation analysis is not required. It is also usually needed just once, for the grant date. and not updated for changes in value in the future. Exceptions would be an ESOP where it is required to have an annual valuation, a company that uses it in on-going communications, the units are subject to liability treatment, or in certain transactions such as redemptions.

For more resources for private companies, check out the Private Company Stock Plans section on NASPP.com