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Private Company Valuation Issues: Guidance for Determining the Fair Value of Common Stock for Purposes of Determining Stock-Based Compensation under FAS 123R

Overview

The FASB's issuance of Statement No. 123R, Share-Based Payment, has highlighted the need for increased focus on the determination of fair value attributed to the common stock of private companies. This increased focus stems largely from the following:

  • Prior to the issuance of FAS 123R the accounting for share-based payment awards was typically reflected in a pro-forma presentation in the notes to the financial statements. Under FAS 123R, the fair value of share-based awards is reflected in earnings.
  • The fair value of common stock is an integral assumption used in the option pricing model selected by management to determine the fair value of its sharebased awards which are ultimately expensed pursuant to FAS 123R.

Purpose

The purpose of this publication is to assist both management and auditors in the determination of the fair value of private company common stock for use in determining stock-based compensation under FAS 123R. The presentation is intended to provide practical guidance on the type of issues often encountered when valuing private company securities.

Issues with Private Company Common Stock Valuation

  • A market does not typically exist for the common stock of a private company.
  • There are usually few (if any) common stock transactions.
  • Common stock transactions when they do exist are often consummated with related parties.
  • Capital formation is typically accomplished by private companies with securities that contain preferences over and above the entity's common shares (preferred stock).
  • Third party valuations are usually not available.
  • Management may be unable to effectively document their consideration of facts and circumstances surrounding the value they ultimately attribute to their common stock. 

Valuation Hierarchy of Consideration

(1) Readily Determinable Market Value

  • To the extent a market exists for the common stock of a private company it should be used to value the common stock.
  • This is likely to be a rare occurrence. However, some examples of this might include a private company that trades on the "pink sheets" or a company that is employee owned thereby creating a market mechanism for its common stock.
  • Keep in mind that although a market mechanism may exist, it should be evaluated to determine whether it is truly suitable for use in determining fair value. For example, a market may exist yet not produce enough measurement points to provide a reliable measure of the fair value of a company's common stock.

(2) Independent Third Party Valuation

  • Absent a readily determinable market value, an independently performed third party valuation of a company's common stock can provide excellent evidence of fair value.
Company's often obtain such valuations for the following reasons:
  • Tax purposes (IRS Section 409(a))
  • Preparation for going public (dealing with the "cheap stock" issue)
  • Requirement of investors

Notwithstanding the value of an independent valuation for accounting purposes, the majority of companies do not have valuation studies performed. This is often due to cost considerations and/or the perception that such a study is not required. Additionally, there are currently no requirements within U.S. generally accepted accounting principles or generally accepted auditing standards for a private company to obtain an independent valuation of its common stock.

Use of Independent Valuation Report

In some cases auditors will strongly recommend the use of a third party valuation. However, they may be limited in the ability to actually require clients to obtain an independent valuation. Management should be aware that its auditors will likely need to weigh the facts and circumstances that surround the issue, including other engagement risks. As a result, an audit report modification may become necessary.

Management and auditors are encouraged to identify material valuation issues early in the audit process to ensure timely resolution of the issue.

AICPA Practice Aid

What should management consider if they decide not to obtain an independent valuation?

  • The AICPA has published a Practice Aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation. FAS 123R describes this guidance as best practice and strongly suggests its use in the valuation of private company securities.
  • Some valuation practitioners have labeled this guidance a de facto FASB, although FAS 123R appears to stop short of a mandate for its use.
  • The Practice Aid guidance is not easy for individuals without a valuation background to understand and therefore the majority of companies will likely be unable to effectively utilize it without the assistance of a valuation expert.

To be clear - the AICPA guidance referred to above should be considered in all situations where its use is recommended, whether or not a third party is utilized by management.

Management Analysis

When is it Necessary

Absent a readily determinable fair value or an independent third party valuation, management should formally document its considerations and conclusion with respect to the fair value of its common stock. The necessity of the analysis and its ultimate depth will depend on the facts and circumstances of each situation. Situations which would generally indicate the need for formal analysis include but are not limited to the following:

  • A company that is seriously considering going public at some point in the future (contemporaneously prepared independent valuations may be required as the IPO is approached).
  • A company that issues a significant amount of share-based payment awards.
  • A company that grants share-based awards for which the attributed fair value has historically been or is expected to be significant.

Sale of Common Stock

Although there may not be enough transactions in the company's own common stock to conclusively define fair value, such transactions can be very meaningful in the overall determination of fair value.

  • Such transactions may be useful as a test of reasonableness by comparing the transactions to the amount management has designated as the fair value of its common stock.
  • Explanations should be obtained for significant differences. For example, the Company sells common stock at $5.00 on November 1, 200X but uses $2.50 to value stock-options granted on December 1, 200X.
  • The weight of such transactions as evidence of fair value increases if they are consummated with unrelated parties at arms length.

Sale of Other Securities

Private companies frequently issue preferred securities. Because of the difficulty of isolating the value attributable to the preferences; it is generally not practical to use the sale of preferred stock to derive a precise value of the common stock without the aid of a valuation specialist.

However, it may be possible to use the sale of preferred securities to gauge the reasonableness of the amount designated as the fair value of the company's common stock.

For example, it has generally been accepted that the old "rule of thumb" approach to determining the value of common stock, typically by setting the value at 1/10th of the price of the most recent round of preferred stock is not a reasonable approximation of the value of the preferences beyond formation and possibly the first round of VC financing. Instances where management has valued its common stock using the 10X rule (or an even greater multiple) are likely to be challenged by auditors.

Although it is generally not practicable to conclude with a degree of precision on the specific value of the preferences (without a valuation specialist), it is generally true that as a company moves toward a liquidation event for the preferred shareholders (e.g., IPO or sale) the value of the common stock begins to converge on the preferred. Accordingly, understanding where the company is in its life cycle may be helpful with respect to the question of common stock value.

For example, during the formative timeframe, often little more than completion of the business plan as occurred and it very subjective as to whether the common stock should be valued at 10:1, 8:1, 5:1 or some other ratio relative to the company's preferred stock.

However, the majority of these companies create business plans with milestones and expected accomplishments that justify future rounds of preferred stock financing at presumably higher valuations.

As milestones are accomplished and as the business progresses the company is able to secure additional rounds of financing thereby reducing the risk of business failure and presumably also resulting in a decrease in the premium paid to preferred stockholders.

Accordingly, if a 10:1 ratio had previously been used to determine earlier common stock valuation, subsequent valuations would be expected to reflect the progress of the business thereby reducing the ratio previously used.

Consideration of Business Objectives, Milestones and Other Factors

Typical factors that may impact the valuation and merit management's consideration include but are not limited to the following (See Appendix for further discussion):

  • Milestones achieved by the entity including those related to technology, sales or other operational achievements.
  • Current state of the entity's industry and the economy.
  • Factors related to its competitive forces.
  • Strategic relationships including those with major customers or suppliers.
  • Major new investors.
  • The current cost structure and financial condition of the company.
  • As progress is made in the business, other factors become increasingly important such as the quality, breadth and depth of the management team.

Timing of Option Grants

Common Stock Value Compared to the Date Share-Based Awards are Granted

One of the common difficulties faced by management and auditors is evaluating the value of the common stock (and its changes) in relationship to date on which share-based awards are actually granted.

For example at December 31, 2007 the company designates the value of its common stock at $10.00 and at December 31, 2008 due to the achievement of significant milestones raises the value to $15.00. Stockbased  awards are granted on July 31, 2008. What is value of the company's common stock at July 31, 2008?

As you might suspect, there is no easy answer to the question. There is however a presumption that management will consider the relative facts and circumstances surrounding the company and its common stock value at the date of grant.

A typical consideration is how value accrues to the common shareholder. If the increase in common stock value in our above example is the result of slow steady progress towards achievement of corporate milestones, there may be an argument that value builds in a linear fashion. However, what if the achievement driving the increase in value is the result of an unexpected breakthrough in the company's technology?

Corporate Governance

In circumstances where the only evidence to establish the fair value of the company's common stock is an analysis prepared by management, management should ensure that reasonable corporate governance procedures are followed.

  • Management should ensure that the board of directors (or other governance body) is involved in the valuation process and ultimately approves the common stock valuation.
  • Ideally, board members are industry experts and seasoned business people well familiar with valuation concepts. Their involvement ensures that a wider range of perspectives is included in the valuation process versus just the view of the executive management team or simply the chief financial officer.
  • The ultimate conclusions reached by the board should be documented in the board minutes. However, sometimes legal counsel will advise otherwise. Documentation in the board minutes is a corporate governance best practice.
  • Auditors will likely need to obtain a management representation specific to the fair value of the company's common stock.

Independence

The valuation of a private company security can be a complex effort requiring the use of a valuation  expert. The question often arises as to whether CBIZ is able to assist a client or perform the valuation services on behalf of the client. The following guidance outlines the issue in this situation:

  • Independence Interpretation 101-3 views valuation services from the perspective of whether the services affect the financial statements.
  • Valuation services contemplated to comply with the requirements of FAS 123(R) are considered to affect the financial statements.
  • Independence 101-14 addresses how the independence rules apply to alternative practice structures such as MHM and CBIZ.

The following table depicts the Firm's independence policy related to valuation services which require us to comply with Interpretation 101-3.

Independence Policy

Prior to the performance of non-attest services for an attest client, it is the obligation of the engagement team to ensure that the requirements of Independence Interpretation 101-3 Non-attest Services have been met.

Summary

Management and auditors should be mindful of the significance of share-based awards. For companies that issue a significant number of share-based awards and/or that have share based awards with significant value, careful consideration of the fair value of the company's common stock is required.

  • Observe the valuation hierarchy
  • Readily obtainable fair value (expected to be rare)
  • Independent third party valuation
  • Analysis prepared by management
  • Management's analysis should consider all relevant facts and circumstances, including but not limited to sales of its own securities (both common and preferred), the achievement of business objectives, key milestones and other indicators of value and the timing of share-based award issuance in relationship to common stock valuation.
  • Ensure the corporate governance process surrounding the valuation process is adequate

Appendix - Stages of Enterprise Development

The stage of operational development of an entity is an important determinant of the value of the entity. An enterprise builds value throughout the various stages of development but rarely is the value built in a linear fashion. Therefore, it is important to recognize that both the stage of development and the achievement of development milestones (or milestone failures) will influence the perception of risk associated with investing in the entity, which ultimately will impact the valuation. The following depict the typical stages of development.

Stage 1

Enterprise has no product revenue to date and limited expense history, and typically an incomplete management team with an idea, plan, and possibly some initial product development. Typically, seed capital or firstround financing is provided during this stage by friends and family, angels, or venture capital firms focusing on early-stage enterprises, and the securities issued to those investors are occasionally in the form of common stock but are more commonly in the form of preferred stock.

Stage 2

Enterprise has no product revenue but substantive expense history, as product development is under way and business challenges are thought to be understood. Typically, a second or third round of financing occurs during this stage. Typical investors are venture capital firms, which may provide additional management or board of directors expertise. The typical securities issued to those investors are in the form of preferred stock.

Stage 3

Enterprise has made significant progress in product development; key development milestones have been met (for example, hiring of a management team); and development is near completion (for example, alpha and beta testing), but generally there is no product revenue. Typically, later rounds of financing occur during this stage. Typical investors are venture capital firms and strategic business partners. The typical securities issued to those investors are in the form of preferred stock.

Stage 4

Enterprise has met additional key development milestones (for example, first customer orders, first revenue shipments) and has some product revenue, but is still operating at a loss. Typically, mezzanine rounds of financing occur during this stage. Also, it is frequently in this stage that discussions would start with investment banks for an IPO.1

Stage 5

Enterprise has product revenue and has recently achieved breakthrough measures of financial success such as operating profitability or breakeven or positive cash flows. A liquidity event of some sort, such as an IPO or a sale of the enterprise, could occur in this stage. The form of securities issued is typically all common stock, with any outstanding preferred converting to common upon an IPO (and perhaps also upon other liquidity events). 1

Stage 6

Enterprise has an established financial history of profitable operations or generation of positive cash flows. An IPO could also occur during this stage. The actual stages during which liquidity events occur or discussions with investment bankers for an IPO take place depend upon several factors. Those factors include, for example, the state of the economy, investor sentiment, and the state of the IPO market.

Excepted from AICPA Practice Aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation.

The information presented herein is not intended to provide comprehensive guidance on valuation techniques or theory, the complexity of which is well beyond the scope of this publication. Additionally, the publication does not intend nor does it cover all possible issues that might arise with respect to the valuation of private company securities. Accordingly, management and auditors are encouraged to carefully consider the specific facts and circumstances related to their situation and consult with experts in the field of valuation theory as deemed necessary.

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