Dataline A look at current financial reporting issues

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1 Dataline A look at current financial reporting issues No July 25, 2013 What s inside: Overview... 1 At a glance... 1 The main details... 1 Contents of the Guide... 3 Overall concepts... 3 Valuation and accounting concepts... 3 Valuation of equity securities and the capital structure... 7 Control and marketability Inferring value from Transactions in the company s securities Relationship between fair value and the stage of development Reliability of the valuation Elements and attributes of the valuation report Accounting and disclosure Questions Valuation of Privately-Held-Company Equity Securities Issued as Compensation AICPA issues updated Accounting and Valuation Guide Overview At a glance On May 29, 2013, the AICPA's Financial Reporting Executive Committee (FinREC) issued the AICPA Accounting and Valuation Guide Valuation of Privately-Held- Company Equity Securities Issued as Compensation (the Guide), which replaces the 2004 edition of the practice aid on this topic. The Guide provides nonauthoritative valuation guidance and illustrations for preparers, auditors, and valuation specialists related to the issuance of privatelyheld company equity securities for compensation. It highlights practice issues related to estimating the fair value of a minority interest in a company s privately issued securities. One of the key changes as a result of the Guide is the focus on transactions in the company s securities and the consideration of private or secondary market transactions in those securities when determining their fair values. The Guide illustrates techniques used to determine the fair value of a company and the methods used to allocate the company s fair value to the components of its capital structure. The main details.1 Preparers, auditors, and valuation specialists continue to encounter challenges when valuing private company securities. The AICPA Equity Securities Task Force (the Task Force), which issued the Guide, was formed to provide guidance on measuring the fair value for financial reporting purposes of privately-held company equity securities issued as compensation. National Professional Services Group CFOdirect Network Dataline 1

2 .2 The Guide was reviewed by FinREC, the senior technical body of the AICPA, and was also available for public comment. While the Guide is nonauthoritative, the practice aid that it replaces was widely recognized by preparers, auditors, and regulators as a resource on the valuation of privately-held stock-based compensation..3 The SEC staff has historically looked at the previous practice aid in it s review of financial statements of companies that are going public. The valuation of equity securities issued as compensation while a company is privately held is often a key accounting issue in many IPO transactions..4 The Guide focuses on the following areas: Overall valuation and accounting concepts relating to the valuation of privately-held company equity securities Valuation of equity securities in simple and complex capital structures Controlling versus minority interests and marketable versus nonmarketable interests How to infer value from transactions in a private company s securities The relationship between fair value and the stage of the company s development and valuation implications of a planned initial public offering Reliability of a valuation and post valuation events Common valuation questions Elements that should be included in a valuation report Accounting and disclosures.5 The Guide also includes separate appendices on the following: The initial public offering process Venture capital rates of return Criteria for selecting a valuation specialist Responsibilities of management and the valuation specialist Table of capitalization multiples Derivation of weighted average cost of capital Real options methods Rights associated with preferred stock Illustration of methods for valuing equity securities Illustrative document request to be sent to the company being valued Illustrative list of assumptions and limiting conditions of a valuation report National Professional Services Group CFOdirect Network Dataline 2

3 .6 The Guide is an update of the 2004 edition of the practice aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. The key changes in the Guide are as follows: New chapter addressing how to infer value from private or secondary market transactions in the private company s securities Detailed discussion on the valuation implications of adjustments for control and marketability Expanded information on how to allocate the value of a company to its debt, preferred stock and common stock New chapter which addresses common valuation questions Contents of the Guide Overall concepts.7 The Guide highlights three methods to value the overall company and its securities: the market, income, and asset approaches. Companies may be valued on a control or minority basis. Since privately-held company equity securities issued as compensation are typically minority shares, a company will often be valued on a minority basis..8 The Guide explains how to allocate the total value of the company to its securities. This allocation should be performed using methods that (i) reflect the going concern status of the company, (ii) assigns some value to common shares, (iii) produces results that can be replicated or approximated, and (iv) have a complexity appropriate to the security being valued. Rules of thumb are not recommended for use as a valuation methodology. The recommended methods described in the Guide are the probability weighted expected return method, the option-pricing method, the current-value method, and the hybrid method. Different methods might be appropriate under different circumstances..9 It is important to consider orderly private and secondary market transactions in the company s securities. Orderly transactions that are contemporaneous with the valuation date must be given some weight when determining fair value..10 In addition to the disclosures required by US GAAP, the Guide recommends that financial statements for an initial public offering (IPO) include the following for each equity award for the twelve months before the date of the financial statement: the number of equity instruments granted, the exercise price and other key terms, the fair value of the common stock, the intrinsic value of any awards, and whether the valuation used to estimate the fair value of the equity instruments was performed on a contemporaneous or retrospective basis. Valuation and accounting concepts Accounting concepts.11 US GAAP provides guidance on the accounting for share-based payments. ASC 718, Compensation Stock Compensation, addresses share-based payments to employees and ASC , Equity Based Payments to Non-Employees, addresses share-based payments to non-employees. Further guidance is provided in SEC SAB Topic 14, Share- Based Payments. National Professional Services Group CFOdirect Network Dataline 3

4 .12 While the guidance in ASC 718 and is based on the concept of fair value, the definition of fair value in that guidance is slightly different than that found in ASC 820, Fair Value Measurements and Disclosures. The fair value definition in ASC 718 and for equity securities exchanged for goods or services is as follows, 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. Fair value for share-based transactions does not incorporate vesting conditions, for example, as well as other exceptions to fair value (e.g., reload features), as found in ASC Accordingly, measurements under ASC 718 and are considered fair-valuebased measures as opposed to fair value measures. Still, the fair value concepts found in ASC 820, 718, and are similar, so the valuation of equity securities will generally be consistent with the guidance in ASC 820. Thus, the Guide recommends following the guidance in ASC 820 unless it contradicts the guidance in ASC 718 and For example, if a security is restricted from trading, other than to qualified institutional buyers, this restriction is a characteristic of the equity instrument that would be transferred to buyers. Under ASC 820, the fair value of the security would be adjusted to reflect the restriction. However, under ASC 718 and , a limited number of transferees (e.g., for non-vested shares) is not a prohibition. As a result, under ASC 718, the value of the security would not be adjusted to reflect this restriction..14 Share-based payments are generally transfers of minority interests. As a result, the unit of value should be a minority interest, not the overall company. Since the market participant buyer would not be able to change the company s strategy or obtain synergy benefits, the valuation should consider the company under current ownership. A company could have more value in exchange if an acquirer was able to obtain synergy benefits as a result of the acquisition. This additional synergy value is generally referred to as a control premium or a market participant acquisition premium. Since a minority shareholder does not have the ability to affect a corporate transaction with synergies or change the operations of the company to have the company operate more efficiently, a valuation of the company under a minority ownership basis should not incorporate such synergy value or control premium..15 Consistent with the guidance in ASC 820, more reliance should be placed on observable inputs than on unobservable inputs. By definition, securities in privately-held entities are not publicly traded. There may, however, be arm s length cash transactions with unrelated parties that can be used to estimate the value of the securities. Management should consider the differences in rights and preferences between the securities in the observed transaction and securities being valued (e.g., preferred stock versus common stock). Management should also consider changes in the value of the company between the transaction date and the valuation date..16 The most reliable evidence of the fair value of a security is from transactions of the same security in an active market. If there is not a quoted market price in an active market or an arm s length cash transaction in the same class of securities, the Guide recommends that management engage a valuation specialist to assist in estimating the value of the securities if management does not have the expertise to perform the valuation. Valuation concepts company valuation.17 The valuation techniques used to value a privately-held company and its securities can be classified as the market, income, and asset approaches. All three approaches should be considered along with the facts and circumstances to determine which National Professional Services Group CFOdirect Network Dataline 4

5 approach is most appropriate. If multiple approaches are used, the results should be analyzed to determine the reasonableness of the values produced by each approach. The reliability of a valuation can be enhanced by using multiple approaches. If there are multiple valuation approaches that yield materially different results, the approaches should be analyzed to understand why there are differences and which is more reliable. A simple average of significantly different values is unlikely to be a reasonable way of estimating value..18 It is best practice to perform a valuation explicitly for the purpose needed. While valuations prepared for different purposes should be generally consistent, it is not appropriate to assume that a valuation performed for one purpose will be suitable for another purpose. The value of the company should consider the state of the industry and the economy, management s competence and experience, the marketplace and competitors, barriers to entry, competitive forces, proprietary assets (either intangible or tangible assets, which tend to enhance value), work force, customers and vendors, strategic relationships, major investors, the cost structure and financial condition, the attractiveness of the industry segment, and risk factors faced by the company..19 The fair value of the total company should be estimated under current ownership and reflect the current required rate of return. The value of the total company in exchange could be higher if potential acquirers were able to improve cash flows or recognize synergies in a business combination, but a minority investor is not able to effect such changes. As a result, the value of the company under ASC 718 and might be different than the value of the company under ASC 350, Intangibles Goodwill and Other. Valuation concepts market approach.20 The market approach is a valuation technique that uses prices and other information obtained from market transactions of similar assets, liabilities, or entities. When valuing a company, the two most common forms of the market approach are the guideline public company method and the guideline company transactions method. For companies that have had sold securities that are different from the securities to be appraised, the backsolve method may be used. These methods are discussed below..21 In the guideline public company method, financial metrics of similar or peer (guideline) companies are compared to the market capitalization of those guideline companies based on the trading price of their individual shares. The guideline company transactions method compares financial metrics to the transaction price that the entire guideline company sold for. These financial metrics may include some combination of revenues, earnings (net income, earnings before interest, depreciation and taxes, earnings before interest and taxes, etc.), cash flow, and book value. In some cases, nonfinancial statement metrics such as price per subscriber (cable industry) or price per bed (hospital industry) could be used. Valuation multiples are computed from the ratios between the metrics and the value of the guideline companies. These multiples would be adjusted to reflect differences between the guideline companies and the target company with respect to growth, profitability, size, and other relevant factors. The multiples are then used to help estimate the value of the target company..22 The Guide introduces the backsolve method. In many early-stage entities, true comparables might not exist. As a result, it could be difficult to apply the guideline public company method or the guideline company transactions method. However, it still might be possible to use another form of the market approach, the back solve method. This method derives the implied value for the company and its securities from a recent arm slength transaction involving the company s securities. Assumptions are made about the National Professional Services Group CFOdirect Network Dataline 5

6 expected time to liquidity, volatility, and risk free rate such that the price paid for the securities can be used to determine the value of the company and its other securities using option pricing methodologies. Valuation concepts income approach.23 The income approach is a valuation technique that converts estimates of future cash flows to a single current amount. The concept behind the income approach is that value emanates from future cash flows. The form of the income approach most commonly used in the valuation of a company is the discounted cash flow method. This method discounts future estimates of cash flows using a discount rate that is appropriate to the risk in the cash flows..24 The cash flows used in the discounted cash flow method can be a single set of cash flows, which represents the weighted average of future outcomes. Alternatively, different possible outcomes can be used in discrete analyses, which would be weighted according to the likelihood of that scenario. Projected cash flows can sometimes represent the scenario cash flows that are expected only upon the success of the company. These success-biased cash flows must be used with caution. Success-biased cash flows should either be converted to expected cash flows (which also consider downside scenarios), used as a possible outcome in a series of discrete analyses, or used independently with a higher discount rate that reflects the uncertainty involved in achieving the cash flows..25 The discounted cash flow method discounts to a present value (most typically at the valuation date) the future estimated cash flows and also discounts to a present value a terminal value, which represents the fair value of all cash flows beyond the end of the projection period. In early stage company valuations, the terminal value might make up more than 100% of the value as there could be cash flow losses in the earlier years..26 Capitalization multiples can be used to calculate the terminal value in a discounted cash flow. A table of capitalization multiples for different discount rates and growth rates can be found in Appendix E of the Guide. Capitalization multiples should be used in terminal value calculations with caution. In many cases, a start-up company is expected to be at a more mature stage by the terminal value period than it is at the valuation date. As a result, using the same discount rate for both discounting purposes as well as for computing a terminal value might not be appropriate. Other methods such as a market approach should also be considered when calculating the terminal value..27 The forecasted cash flows represent a significant input into the discounted cash flow model and should be carefully estimated by management. In the early stages of a company, it may be difficult to estimate future cash flows. Other key inputs include the discount rate and terminal value assumptions. The discount rate should consider both systematic risk of the investment, and the risk associated with meeting the particular cash flow projections, if that risk is not already adjusted for in the cash flows..28 The capital asset pricing model is sometimes used to compute the company s cost of equity capital. It estimates a company s cost of equity capital by comparing the company s equity risk with the risk and return in the stock market. Appendix F of the Guide provides a derivation of a discount rate using the capital asset pricing model. National Professional Services Group CFOdirect Network Dataline 6

7 For early stage companies, the capital asset pricing model might only represent part of the required return in the cost of equity capital. The capital asset pricing model uses Beta (the covariance of return of a security with the overall market) to estimate risk. Beta measures the riskiness of an asset in comparison to the risk found in the stock market. In many early stage companies, the company will be subject to additional start-up risks that are not explicitly captured by the capital asset pricing model..29 Appendix B of the Guide provides venture capital rates of return from a variety of sources. This appendix references rates of return data and studies performed by James Plummer (QED Report on Venture Capital Financial Analysis, 1987) and Daniel Scherlis and William Sahlman (A Method for Valuing High-Risk, Long Term, Investments: The Venture Capital Method, Harvard Business School Teaching Note (Boston: Harvard Business School Publishing, 1989). Rates from various studies are displayed in the table below. Stage of Development Rates of Return Startup 50% - 100% First Stage/Early Development 40% - 60% Second Stage/Expansion 30% - 50% Bridge/IPO 20% - 35% While it is useful to observe the rates of return found in studies, the observed range of rates of return is very wide and it is possible that the required rates of return for a company in an early stage of development will fall outside the range. It is considered a best practice to test the results of an income approach using venture capital rates of return with another methodology such as the backsolve method. Valuation concepts asset approach.30 The asset approach looks at the value of the company as the value of its underlying assets and liabilities. The asset approach is typically only used in the earlier stages of a business, before intangible assets and goodwill have significant value. Valuation of equity securities and the capital structure Simple capital structure.31 In a simple capital structure with only debt and common equity, the fair value of the common equity is equal to the fair value of the total company less the fair value of the debt..32 The fair value of debt can be different from its book value. A fair value of debt that is higher than book value of debt indicates that interest rates have fallen or that the credit worthiness of the company has increased. A fair value of debt lower than book value could indicate a period of rising interest rates or a decreasing credit rating for the company..33 If the debt is traded, the traded price is often the best estimate of its fair value. National Professional Services Group CFOdirect Network Dataline 7

8 If the debt is traded, the Guide indicates that the traded price may be the best estimate of its fair value. We believe this is to allow for unique situations and that the traded price will often be the best estimate..34 If the debt is not traded, the fair value of debt is typically estimated using an income approach in which the debt payments are discounted using market yields. The duration of the debt must be considered in accordance with the terms of the debt, including calls or puts. For example, debt that is callable might be called if it is paying a coupon that is higher than the rate at which the company could refinance the debt. This would decrease the duration of the debt. Complex Capital Structure.35 Many entities (especially those with private equity and venture capital investors) have complex capital structures with multiple classes of preferred stock. This is driven by a desire by investors to seek economic rights and significant control over the company s activities. Some of the economic rights demanded by preferred investors include liquidation preference, preferred dividends, mandatory redemption rights, conversion rights, participation rights, anti-dilution rights, and registration rights. Some of the control rights given to preferred investors include voting rights, protective provisions and veto rights, board participation, drag-along and tag-along rights (defined in the Guide), right to participate in future rounds, first refusal rights, management rights, and information rights..36 In the past, many early stage companies used rules of thumb to estimate the value of their common shares (using transaction prices for their other securities). Rules of thumb do not provide a reasonable and supportable fair value estimate. The Guide recommends that in selecting the method used to value the equity securities, the following be considered: The going concern status of the company Some value is allocated to the common shares (unless the company is being liquidated and common shareholders will not receive any value) The results can be independently replicated The complexity of the method is appropriate to the company s stage of development.37 There are four methods for allocating between classes of equity securities: the probability-weighted expected return method (PWERM), option-pricing method, the current-value method, and the hybrid method..38 The PWERM explicitly considers the economic rights of each share class and computes their value under different scenarios. It uses estimates of different possible future outcomes available to the company (e.g., IPO, merger, or sale) to compute the value of the equity securities under these different scenarios. The values computed for the equity securities should be adjusted (if appropriate) for discounts such as for illiquidity. The values are discounted to a present value and multiplied by a percentage that represents the probability of each scenario occurring. National Professional Services Group CFOdirect Network Dataline 8

9 .39 The PWERM is frequently used when the company is close to an exit event and different exit event values may be estimated with greater reliability. When the time to an exit event is more uncertain, it can be difficult to develop reliable detailed assumptions about possible future outcomes..40 The option-pricing method treats the company s securities as call options on the company s value. This method explicitly recognizes and models the payoffs of the various share classes that resemble option-like payoffs. The exercise prices of the securities are based on the principal and coupons of debt and the liquidation preferences and dividends of preferred stock. The common stock is modeled as the right to receive the value of the company above the amounts that must be paid to debt and preferred equity..41 The option-pricing method calculations can be computed on the equity, or on the company s total capitalization. When using the total capitalization, debt needs to be considered as one of the breakpoints in the option analysis. The volatility assumptions need to be consistent with the equity or total capitalization assumptions..42 A criticism of the option-pricing method is that the Black Scholes option pricing model (the primary model for estimating future outcomes in the option-pricing method) assumes a log normal range of future possible outcomes. Some early stage companies may not have the smooth distribution of outcomes that is predicted by the Black Scholes option pricing model. The inputs to the option-pricing method should be carefully considered. The term of the options are generally taken as the expected time to a liquidity event, even though the timing of the liquidity event may be uncertain. Volatility is estimated as the average volatility over the expected term. As a result, the volatility estimate should consider that a developing company will often have higher volatility during the early stages than during the later stages when it is a more mature company..43 The current-value method first computes the value of the equity on a control basis (typically assuming a sale of the company) and then allocates that value to the various series of preferred stock-based on liquidation preferences and/or conversion ratios. Any remainder is then allocated to the common equity..44 The primary advantage of the current-value method is that it is easy to apply and understand. The primary disadvantage is that the value that is allocated to the common equity does not consider the option-like nature of common stock and thus the method does not consider possible changes in the value of the company. As a result, the Guide recommends that the current-value method only be used when a liquidity event is imminent (minimizing changes in time and changes in the value of the company) or when the company is at such an early stage of development that no material progress has been made on its business plans (and no value beyond liquidation preferences could yet be expected)..45 The hybrid method takes the scenarios found in a PWERM and uses an option pricing methodology on each of the scenarios. This method is useful when there is a significant uncertain event that could materially affect the value of the company. As a result of this single uncertain event, the range of future possible outcomes might no longer be represented by a log normal distribution..46 An advantage of the hybrid method is that it applies the conceptual framework of the option pricing method to different scenarios. A disadvantage of this method is that it may be complex and require a large number of assumptions. National Professional Services Group CFOdirect Network Dataline 9

10 .47 The appendices included in the Guide provide comprehensive examples of valuations performed under the current value method, option-pricing method, PWERM, and hybrid methods. While facts and circumstances for each individual situation should be considered when performing a valuation, these examples are helpful in demonstrating how to perform a valuation analysis using these complex methods Control and marketability Control considerations.48 The valuation of a company can be prepared on a control or minority basis and on a marketable or nonmarketable basis. If the company is not valued on a basis commensurate with the equity securities (minority and nonmarketable) being valued, adjustments might be needed so that the valuation of the company is consistent with the terms of the equity securities..49 A valuation prepared on the basis of a change in control (which includes synergy benefits that would be achievable by an acquirer in a transaction) should be adjusted so that the company is valued on a minority basis (without synergy benefits). A control premium (also called a market participant acquisition premium) is a premium paid to acquire another company above the value of the company under current ownership. Control premiums are generally paid because the acquiring company can obtain synergies that were not available to the acquired company on a stand-alone basis..50 It may be appropriate to consider control and synergy assumptions in the terminal value if a sale is assumed at that date. These are benefits that a minority shareholder would be able to obtain. Marketability considerations.51 If a security with limited marketability should have a lower fair value than an equivalent security that is currently marketable..52 For entities with complex capital structures, it might be appropriate to apply an additional discount for lack of marketability to the junior securities as the junior securities could be less marketable than more senior securities..53 In computing discounts for lack of marketability, some of the factors to be considered include the estimated time to liquidity (for the securities or the entire company), restrictions on the transferability of the securities, the pool of potential buyers, risk or volatility, the size and timing of distributions, and concentration of ownership. National Professional Services Group CFOdirect Network Dataline 10

11 It is common for a privately-held company to be valued as a company with limited marketability. For example, if a venture capital stage company is valued using a 35% discount rate, the valuation of the company already incorporates a discount for an investment with limited marketability. An additional discount applied to the resulting valuation could double count the marketability discount already reflected in the discount rate..54 Several methods have been proposed to estimate a discount for lack of marketability. The most popular model is based on the protective put model, which estimates the discount as the value of an at-the-money put with a life equal to the restriction divided by the marketable stock value. The theory is that if an investor had this downside protection, the investor would be indifferent to selling the shares because the downside risk has been eliminated..55 Several methods have been proposed to help improve the reliability of the protective put method: the Finnerty Method, which uses an average strike price put option, the Asian protective put method, which uses an average price over the restriction period, and the differential put method, which estimates the difference between the protective put discount for the preferred stock versus the protective put discount for the common stock..56 Estimating a discount for lack of marketability continues to be challenging. The factors relevant to the discount, the duration of the discount, the volatility of the underlying shares and other factors need to be carefully considered. Inferring value from transactions in the company s securities.57 Transactions in a private company s securities should be considered in the valuation of privately-held-company equity securities issued as compensation. It may be possible to use the transaction to estimate the total value of the company and the value of the securities of the company..58 Some transactions in the company s securities might not be representative of fair value. Inside rounds of financing, where there are no new investors, may provide a reliable indication of fair value if it is negotiated well and pricing follows progress of the company since the last investment round. If the inside round only uses the pricing found in the last round without such considerations, it may not be a good indicator of fair value. Transactions in which an investor also gains a strategic relationship (or negotiates the right to use intellectual property) should be viewed with caution as it is difficult to know if the investor purchased a business relationship along with the equity interest. In a situation with a strategic relationship between the buyer and seller, it is also possible that the seller might sell the shares at a discount to acquire a strategic relationship or at a premium if the buyer needs the strategic relationship for its business..59 When one company s private equity securities are transferred for another company s private equity securities, the fair value of the securities transferred for consideration should be determined. Although the transaction documents might specify the value of the securities, this price should be tested using valuation methodologies. It is not appropriate to simply rely on the price specified in the documents..60 ASC 820 established a fair value hierarchy that gives the highest priority to observable inputs and the lowest priority to unobservable inputs. As a result, it may be more appropriate to rely upon secondary market transactions than model-based estimates of value. If the transaction is orderly, the Guide recommends that the transaction price be considered. An orderly transaction is defined by ASC 820 as a transaction that assumes exposure to the market for a period before the measurement National Professional Services Group CFOdirect Network Dataline 11

12 date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale)..61 The Guide notes that if a company is unable to conclude that the transaction is not orderly, the transaction price should be given some weight in measuring fair value. In determining how much weight to place on secondary market transactions, factors to consider include: timing of the transaction, sufficient sophisticated bidders, sufficient information, pattern of trades, and other factors or biases that could affect the observed price. Based on discussions with the SEC staff, if a transaction isn t shown to be disorderly, some weighting of the transaction price should be considered. Relationship between fair value and the stage of development.62 The stage of development of the company must be considered when valuing the company s equity securities. These stages range from a pre-revenue company to a mature company with established profits and cash flows. The stages are marked by a number of milestones for the early stage company. These milestones begin with a business plan, financing, concept, and progress to a profitable mature company. As a company moves through these milestones, the value of the company (and the equity securities of the company) increases as the company matures and risk is reduced..63 Information that is available to determine the fair value of a company will change depending on the stage of development of the company. Pre-revenue companies are unlikely to have reliable forecasts. Companies that are near an IPO are more likely to have reliable information with which to value the company. Therefore, valuation techniques might differ depending on the stage of development of the company..64 Stages 1-2 Pre-revenue companies often have difficulty preparing reliable forecasts. This makes an income approach difficult to perform. As there are few metrics to be used for valuation purposes, a market approach (guideline public company or guideline company transactions method) might not be reliable. If reliable and relevant transactions have occurred at arm s-length, the backsolve method generally gives the most reliable indicator of value. An asset accumulation method could be appropriate if significant intangible asset value has not yet been created and if no recent rounds of financing are available..65 Stages 3-4 As the company still has no or very limited revenue, an income approach might still be difficult to perform due to the difficulty in preparing reliable forecasts. If an income approach is used, high discount rates would likely be needed to reflect the uncertainty of achieving the projections, which may be success biased. Similarly, a market approach will sometimes be difficult to perform due to the lack of reliable metrics and the challenges in finding guideline companies at a similar stage of development. Still, the information should be more available than it was for Stages 1-2. As there will typically have been multiple rounds of financing, a backsolve method might provide a reliable indicator of value. An asset accumulation method might not be appropriate if significant intangible asset value creation has occurred..66 Stages 5-6 As the company matures and has meaningful sales, it should be possible to prepare forecasts in order to perform an income approach. As the company approaches break even or experiences positive cash flow, such forecasts should be more reliable. It should also be possible to find companies that are at a similar stage of development so that a market approach can be performed. If there are recent rounds of financing, a backsolve method might be a reliable indicator of value. The asset National Professional Services Group CFOdirect Network Dataline 12

13 accumulation method is unlikely to provide an appropriate measure of the fair value of the company as the company likely has goodwill and other intangible assets that aren t typically valued under an asset accumulation method..67 IPO As the company matures and approaches an IPO, it may begin to receive estimates of the ultimate IPO price. Still, for a pre-ipo company, the price before and after a successful IPO could be materially different as the company s cost of capital should be lower after a successful IPO. An IPO also reflects that the market perceives a lower risk for the company than it did before the IPO. When a company nears an IPO, the income and market approach can generally be reliably performed. The backsolve method might be appropriate if there were recent rounds of financing. The asset accumulation method is unlikely to provide a reliable measure of the fair value of the company at this stage. The SEC staff will generally be skeptical if the IPO price is significantly greater than the estimated value of the shares issued shortly before the IPO. While there are uncertainties that will exist up to the IPO, the estimated IPO price at the valuation date should be considered as an input into the valuation of shares issued in the twelve months before an IPO. Reliability of the valuation.68 A valuation report that is prepared contemporaneously with the valuation date will not be biased by hindsight..69 Many privately-held companies are reluctant to obtain contemporaneous valuations during the early stages of development due to cost considerations. Before deciding not to obtain such valuations, companies should consider that fair value based measurements are required for stock, options, warrants, and other securities issued to employees, so a reliable fair value measure is needed to properly record such transactions. While the reliability of the valuation can be enhanced with the use of outside valuation specialists, the company s management is responsible for the underlying assumptions and measurements used in preparing the financial statements..70 Procedures that the valuation expert might need to consider when performing a fair value estimate include: interviewing management, examining cash and other transactions between the company and its creditors, identifying milestones and significant events that can influence value, analyzing monthly financial information and cash flows, considering past events, and reviewing contemporaneous budgets and forecasts as of the valuation date..71 There may be other events that affect the value of the company after the valuation date. If these events were known or knowable before the valuation date, they should be incorporated into the value. If they were not known or knowable, market participants would not have considered such information as of the valuation date. We believe reasonable efforts should be made to identify known or knowable events at the valuation date that affect the value of the company. Judgment will be required to determine what is reasonable in a particular circumstance. National Professional Services Group CFOdirect Network Dataline 13

14 Elements and attributes of the valuation report.72 Valuation reports should be complete, well organized, and written. It may be necessary to share the valuation report (and in some cases, backup documentation) with others, such as auditors or regulators..73 Valuation reports should follow the provisions of Statement on Standards for Valuation Services No. 1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset (SSVS No. 1). SSVS No.1 suggests the following sections in a detailed report: letter of transmittal, table of contents, introduction, sources of information, analysis of the subject company, financial statement/information analysis, valuation approaches and methods considered, valuation approaches and methods used, valuation adjustments, nonoperating assets (and liabilities), representation of the valuation analyst, reconciliation of estimates and conclusion of value, qualifications of the valuation analyst, and appendices and exhibits..74 SSVS No.1. provides that the valuation report should be sufficient to allow the reader of the report to understand the nature of the business, the scope of the valuation engagement, and the work performed..75 A valuation report should also contain the following: Summary of current and future economic conditions Overview of the industry Overview of the company s operations Key value drivers Discussion of the company s historical and expected financial performance Discussion of valuation approaches used Discussion of the assumptions and calculations Statement as to whether the report was prepared by an unrelated party Statement that the valuation specialist cannot guarantee the forecasted results The valuation specialist s qualifications should also be specified in the report.76 The Guide recommends that valuation reports provide a point estimate of value as opposed to a range of values. Accounting and disclosures.77 Per the guidance in ASC 718, the cost of equity-classified share-based payments to employees is determined based on the grant date fair value of the awards and is recognized over the period during which service is required, usually the vesting period..78 Per ASC , the fair value of share-based payments to non-employees must be determined in order to recognize in the financial statements the most reliable measure of such payments and thus the cost of providing the share-based payments..79 ASC 718 and ASC indicate that a company with share-based payment arrangements should disclose sufficient information to enable the users of the financial National Professional Services Group CFOdirect Network Dataline 14

15 statements to understand: the nature and terms of share based payment arrangements, the effect of compensation cost arising from share based payments, the method of estimating the fair value of the goods received or share based payments granted, and the cash flow effects of the share based payment arrangements..80 Disclosures about risks and uncertainties under might be required due to the use of estimates and judgments in the valuation of privately issued equity securities..81 ASC 718 and ASC are fair-value-based as they consider certain exceptions to fair value such as vesting provisions and reload features. ASC specifically states that the guidance in ASC 820 does not apply to share based payments. Still, the Guide explains that many concepts found in ASC 820, such as market participant assumptions, restrictions following a security, nonperformance risk, etc., are relevant to the valuation of share based payments under ASC and ASC The Guide recommends that financial statements included in an IPO include the following for the 12 months prior to the date of the most recent financial information: information on grant dates, the number of equity instruments granted, exercise price and other key terms, fair value of the common stock at each grant date, and the intrinsic value of each equity instrument granted. Disclosure of whether the valuation of the equity instruments was contemporaneous or retrospective should also be included. Management s discussion and analysis should include a discussion of the significant factors, assumptions and valuation techniques. A discussion of significant factors that contributed to a difference between the fair value on each grant date and the IPO price should also be included..83 If a report, valuation, or opinion of a valuation expert is included in a registration statement or prospectus filed with the SEC, the company will need to provide the name and written consent of the valuation expert under the Securities Act of The valuation expert becomes expertised and is subject to liability. If management relies on the work, but does not disclose the report valuation or opinion, the valuation expert is not considered an expert for the purposes of filing with the SEC. Questions.84 PwC clients that have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact the RLO team in the National Professional Services Group ( ). National Professional Services Group CFOdirect Network Dataline 15

16 Authored by: Lawrence Dodyk Partner Phone: Dusty Stallings Partner Phone: Richard Billovits Director Phone: Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. They are for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network ( PwC s online resource for financial executives PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details.