Understanding the Challenges of Estimating the Value of Equity Issued in Lieu of Compensation
There’s an ongoing struggle in estimating the value of equity issued in lieu of compensation by companies that are not publicly traded and have never had a 409A valuation performed. This becomes a big item of discussion when you need GAAP financial statements prepared for current or potential investors, because GAAP requires equity issued in lieu of compensation to be recorded based on the fair market value of the equity instrument issued. It’s a discussion I’ve had many times with my clients, and the following are just a few scenarios to consider that may impact the value.
A recent transaction has occurred in which equity was issued to a third-party buyer. Startups can use this transaction as a starting point for the value of the equity or options issued to employees or consultants in lieu of compensation. But it’s also important to consider if the shares are truly equivalent. Was the equity issued in lieu of compensation restricted? Was the equity issued in the form of common shares, preferred shares, or were they options to buy at a fixed price? Does it have the same ownership rights? Does it vest over a future service period? These differences may provide a need for applying discounts, taking into consideration the time value of money, or adjusting for the volatility of the shares that were issued. Black-Scholes models are often used to assist with these calculations.
There have been no third-party transactions, and all you have to go on is the par value of the stock. Arguments for valuing the equity higher than par could depend on transactions that have occurred with the company to date. Depending on the industry of your business, maybe your 510(k) filing was approved by the FDA, you received your first order for 100,000 widgets, your patent was approved, or your customer land-and-expand strategy continues to increase your MRR. If these types of transactions have occurred, then using your par value as the fair value of the equity issued to employees or consultants may be challenged by the IRS or other parties as being too low.
Some transactions with third parties have occurred, but not recently. You may believe your company is not worth much at this point in time because the company is in a slump or is looking to pivot. Maybe the technology platform you’ve been building has to be scrapped—but how can you prove that when you sold 1,000 shares for $100,000 six months ago? What’s happened between now and then to decrease the value of the equity now being issued in lieu of compensation? What story can be told to bridge that gap?
A potential solution to this struggle is in the works. The Private Company Council of the Financial Accounting Standards Board has been discussing a practical expedient to measure the fair value of equity in lieu of compensation. The practical expedient could allow private companies to use the exercise price as the fair value of an award in certain circumstances, but the research on this possible resolution is ongoing.
Estimating the value of equity issued to employees or consultants in lieu of compensation is difficult. Make sure to discuss these considerations with your accountants and legal advisors; they could have an unexpected impact on your financial statements.
Marilea Campomizzi, CPA
Skoda Minotti Emerging Companies Group
Do you have questions about estimating the value of equity in lieu of compensation, or other emerging company issues? Please contact Marilea Campomizzi, CPA, at phone 440-449-6800 or email@example.com.