Defining Issues June 2013, No

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1 Defining Issues June 2013, No AICPA Issues Practice Aid for Valuation of Privately-Held-Company Equity Securities Issued as Compensation The AICPA recently issued a Practice Aid addressing the valuation of privatelyheld-company equity securities issued as compensation (the Practice Aid). 1 The Practice Aid addresses: Contents Relevant Fair Value Concepts 1 Basis of Valuation 2 Leading Practices for Estimating Fair Value 2 Adjustments for Lack of Control 6 The application of ASC Topic 820 to measuring privately-held-company 2 equity securities issued as compensation; Considerations for determining the appropriate basis of valuation (e.g., a minority interest subject to current ownership versus the sale of a controlling interest in an entity); 3 Leading practices for estimating the fair value of privately-held-company equity securities based on the company s stage of development; Factors to consider for determining control and marketability adjustments; The consideration of private and secondary market transactions in the security in the valuation process; and Disclosures in the financial statements and Management s Discussion and Analysis (MD&A) that could be included in an initial registration statement. Relevant Fair Value Concepts ASC Topic 718 and ASC Subtopic provide guidance about accounting for transactions in which an entity exchanges its equity instruments for goods or services. 4 The equity instruments used for compensation purposes may be either in the form of shares or share options on the entity s equity securities. Adjustments for Lack of Marketability 6 Inferring Value from Transactions in a Private Company s Securities 8 Recommended Disclosures 9 1 The AICPA s Accounting and Valuation Guide: Valuation of Privately-Held-Company Equity Securities Issued as Compensation, supersedes the 2004 Practice Aid, Privately-Held-Company Equity Securities Issued as Compensation (2004 Practice Aid), historically referred to as the Cheap Stock Guide. The new Practice Aid is nonauthoritative and was developed by the AICPA staff and the AICPA Equity Securities Task Force and is available for purchase at 2 FASB ASC Topic 820, Fair Value Measurement, available at 3 It should be noted that the minority interest discussed in the Practice Aid is written from the perspective of the holder. This is different from a noncontrolling interest (also sometimes referred to as minority interest) addressed in FASB ASC Topic 810, Consolidation, which is written from the perspective of the parent. 4 FASB ASC Topic 718, Compensation Stock Compensation, and FASB ASC Subtopic , Equity Equity-Based Payments to Non-Employees, both available at

2 Considerations When Using the Practice Aid The Practice Aid is specifically intended for valuing minority equity interests in privately-heldcompanies for share-based compensation purposes. Many of the Practice Aid s concepts may be relevant to valuations conducted for other purposes; however, caution is advised when applying these concepts to valuations conducted when valuing controlling interests such as goodwill impairment testing and portfolio company valuations. The measurement of compensation cost is a fair value-based measure, which differs somewhat from fair value as used in ASC Topic 820. For example, the grant date fair value in share-based payment arrangements does not incorporate vesting conditions into the valuation. The Practice Aid provides a summary of the fair value concepts in ASC Topics 820 and 718, and Subtopic The valuation of private equity securities that underlie a share-based payment would generally follow the valuation principles of ASC Topic 820. Therefore, the Practice Aid recommends following the measurement guidance in ASC Topic 820 except where the measurement requirements in ASC Topic 718 and ASC Subtopic specifically differ from the guidance in ASC Topic 820. Basis of Valuation The Practice Aid states that the basis of value for measuring privately-heldcompany equity securities issued as compensation should be that of a minority, nonmarketable interest in a privately-held-company. It clarifies that the market participant or willing buyer contemplated in the fair value definition is the hypothetical buyer for the minority interest, not a hypothetical buyer for the entire entity. Accordingly, the objective is to value the individual securities of the entity, rather than to value the entity itself. Because a market participant who purchases a minority interest in the entity would not be able to change its strategy, the valuation should reflect the plans of the entity under its current ownership structure, rather than assuming its sale on the measurement date. The value of a minority interest is typically determined using a top-down approach where the enterprise value is first determined. Then the fair value of debt is deducted from the enterprise value with the remaining value being allocated to the equity shareholders based on their economic and control rights. Leading Practices for Estimating Fair Value Three Valuation Approaches Income Market Asset The Practice Aid summarizes the three valuation approaches described in ASC Topic 820 (income, market, and asset) that may be used to value an entity and its equity securities. In particular, the backsolve method (a market approach), which allows an entity to solve for its implied aggregate equity value by considering its recent equity transactions with unrelated parties, is discussed. Importantly, the Practice Aid notes that use of rules of thumb (e.g., percentage of preferred stock sales price or discount to anticipated initial public offering (IPO) price) is not appropriate when determining the fair value of minority interests in common stock. The Practice Aid states that the following should be considered when determining the appropriate valuation approach: The entity s stage of development; 2 / Defining Issues / June 2013 / No

3 The entity s capital structure (i.e., simple or complex); and The availability of recent transactions involving the entity s own securities. An entity s stage of development is an important consideration in the determination of the appropriate valuation approach because the entity s value can be expected to change as it moves from one stage to another. Income, market, and asset approaches should be considered in all stages of development, but in some stages only one or two approaches will be appropriate. For example, the market or income approach may be impractical for an early-stage entity given the lack of market data for similar businesses, as well as financial forecasts. The asset approach, generally considered the conceptually weakest approach for valuing a business, may be the only one available for an early-stage entity. As a business matures, the income and market approaches will become more appropriate. The backsolve method may be relevant at any stage of development if transactions occur close to the measurement date and at arm s length. Four Allocation Methods Probability-weighted expected return method Option pricing method Current-value method Hybrid method The Practice Aid presents many factors that should be considered regardless of the approach selected; for example, milestones achieved, the financial and operating performance of the entity, and the prospects for an IPO. The capital structure of the entity also should be considered. The equity of an entity with a simple capital structure (i.e., a single class of stock and possibly options and warrants on that stock) would be valued by first determining the enterprise value based on cash flows expected to be generated under current ownership and the investors required rate of return. The Practice Aid notes that the enterprise value when valuing a minority share (i.e., under current ownership) is not necessarily the same as the enterprise value when valuing the entire entity. The underlying premise is that under current ownership the minority investors would be expected to share in the returns to the other investors in aggregate. The valuation of a minority, nonmarketable interest in a privately-held-company would be based on a pro-rata share of the enterprise value under current ownership less the fair value of debt. Subsequently, adjustments may be made if appropriate for differences in the return that a market participant purchasing the minority securities would require, given any differences in the economic or contractual rights of the minority securities. For an entity with a complex capital structure, value would be ascribed to the various classes of equity, which requires understanding the economic and control rights associated with each class. The Practice Aid presents four methods to attribute value to the different equity classes when determining the fair value of a minority interest, and states that no one method is necessarily appropriate in all circumstances. Instead, the Practice Aid provides a list of factors to consider when determining which method to use. The methods that might be used are: 3 / Defining Issues / June 2013 / No

4 (1) Probability-Weighted Expected Return Method (PWERM). Under the PWERM, the value of the equity securities is estimated based on an analysis of future outcomes as well as the interim cash flows associated with any additional financing required to reach the modeled exit scenarios. The anticipated future outcomes that are modeled (e.g., IPO, merger or sale, dissolution, or continued operation as a private enterprise until a later exit date) must be consistent with the expectation under current ownership. An explicit valuation of the entity as of the valuation date is not required. Typically, because the capital structure used in the PWERM allocation should include both the future payoff amount for the debt as well as any future rounds of financing that the company will need to reach that future exit, the PWERM is used when the company is close to an exit point and does not plan on raising additional capital. The Practice Aid suggests reconciling the probability-weighted present values of the future exit values to the overall equity value of the entity to assess the overall reasonableness of the valuation. In a PWERM framework, the backsolve method for inferring the equity value implied by a recent financing transaction involves selecting the future outcomes available to the entity. The future exit values, the probabilities for each scenario, and the discount rates for the equity securities should be calibrated so the value derived within the PWERM framework for the securities equals the price paid for those securities in the financing transaction. The PWERM explicitly considers the rights of each share class at the date in the future that those rights will either be executed or abandoned. The primary limitation of the PWERM is that it is complex to implement and requires significant judgment to develop assumptions about potential future outcomes. The PWERM is generally more appropriate when the time to a liquidity event is short because the range of possible future outcomes is easier to estimate. (2) Option Pricing Method (OPM). The OPM treats common stock and preferred stock as call options on the entity s equity value, with liquidation preferences of the preferred stock used as exercise prices. The common stock only has value under this method if the funds available for distribution to shareholders exceed the value of the liquidation preferences at the time of a liquidity event. The common stock is therefore modeled as a call option with a claim on the equity at an exercise price equal to the remaining value after the preferred stock is liquidated. The Black-Scholes-Merton model is commonly used to price the call options. One of the critical inputs into the OPM is the total equity value that generally is based on the estimated cash flows under current ownership and the investors required rate of return for the entity. Because the liquidation preferences for the preferred stock protect the return for those investors 4 / Defining Issues / June 2013 / No

5 before the common stock begins participating, the enterprise value should be consistent with the investors required rate of return. If any recent financing transactions by the entity are available, the backsolve method for inferring the equity value implied by a recent transaction should be considered. The backsolve method in the OPM involves making assumptions for the expected time to liquidity, expected volatility, and riskfree rate and then solving for the value of equity so the value derived within the OPM framework for the securities equals the price paid for those securities in the financing transaction. This method is most appropriate when the financing transaction is an arms-length transaction and is pari passu (of equal seniority) with previous rounds. If the transaction is distressed or reflects a less liquid transaction than the previous rounds, adjustments to the price before the backsolve method should be considered. The OPM considers the evolution of the equity value without allowing for proceeds raised in additional financings. Only outstanding options and options expected to be issued in the short term regardless of any changes in the entity s value are included in the allocation. The allocation does not include the dilution impact of additional financings, nor of any options and warrants that may be issued as the entity progresses toward a future liquidity event. An advantage of the OPM is that it explicitly recognizes the option-like payoffs of the various share classes utilizing information in the underlying asset (i.e., estimated volatility) and the risk-free rate to adjust for risk by adjusting the probabilities of future payoffs. The primary limitation of the OPM is that it assumes that future outcomes can be modeled using a lognormal distribution. The method is also sensitive to certain key assumptions, such as the volatility assumption, that are not readily supported by market evidence. Another disadvantage of the OPM is that it considers only a single liquidity event, and therefore does not completely capture the characteristics of other potential future liquidity events. The OPM (or a related hybrid method) is the most appropriate method to use when specific future liquidity events are difficult to forecast. (3) Current-Value Method (CVM). The CVM is developed by first estimating equity value on a controlling basis, assuming an immediate sale of the entity, and then allocating that value to the preferred stock based on its liquidation preferences or conversion values, whichever would be greater. Because the CVM focuses on the present and is not forward-looking, this method is limited primarily to two types of circumstances: (1) when a liquidity event in the form of an acquisition or dissolution of the entity is imminent, and expectations about the future of the entity as a going concern are virtually irrelevant, or (2) when an entity is at such an early stage of its development that: (a) no significant progress has been made on the entity s business plan; (b) no significant common equity value has been created in the business above the liquidation preference on the preferred shares; and (c) no reasonable basis exists for estimating the amount and timing of any 5 / Defining Issues / June 2013 / No

6 common equity value above the liquidation preference that might be created in the future. (4) Hybrid Method. This method combines the PWERM and OPM methods and is developed by estimating the probability-weighted value across multiple future outcomes, while using the OPM to estimate the allocation of value within one or more of those scenarios. Hybrid methods rely on the framework of option-pricing theory to model a continuous distribution of future outcomes as well as capture the option-like payoffs of the various share classes while also explicitly considering future scenarios and the discontinuities in outcomes for early-stage companies. Similar to the PWERM, a disadvantage is that these models require a large number of assumptions and may be quite complex. Adjustments for Lack of Control The basis of valuation for the entity should be consistent with the amount that investors would pay for the interest in the entity under current ownership and the investors required rate of return (i.e., based on the existing capital structure). The determination of value under the market approach would be based upon multiples that reflected current ownership. Likewise, the cash flows relied upon in the income approach would reflect expected cash flows under current ownership. Any value expected to be realized from a liquidity event may be included. Until a liquidity event occurs, the expected cash flows to the primary and minority investors would be identical because the cash flows are projected under current ownership. Although the enterprise value used to value the primary and minority interests is identical, the securities could differ due to economic or control rights. In general, the Practice Aid states that differences in value may be captured by modeling explicit rights and preferences of different securities. A discount for lack of control (DLOC) should be minimal if these explicit rights and preferences are already captured in the modeling. There may be situations, however, where differences in rights are not captured in the modeling and a DLOC may be appropriate. For instance, the primary investors may have significant control over the timing of an exit and the negotiations for future financing rounds, while the junior securities may lack these rights. Relative to the economic rights, it would be more difficult to capture these control rights in the modeling. The Practice Aid cautions against using the inverse of acquisition premiums from publicly available data and instead suggests that a comparison of voting to nonvoting stock may be more appropriate. Adjustments for Lack of Marketability The primary investors securities and the entity as a whole should be considered to be equally marketable. This is the case because the enterprise value is based on the cash flows expected to be received by the private equity or venture capital investors. Junior securities in complex capital structures, however, are 6 / Defining Issues / June 2013 / No

7 typically less marketable because: (1) the holders of these securities do not have access to the same level of information as senior securities holders, and (2) the holders of junior securities contractually may not hedge or diversify their investments. A discount for lack of marketability (DLOM) may be appropriate to reflect these attributes. There are many factors to consider in deriving a DLOM, including (1) prospects for liquidity; (2) number, extent, and terms of existing contractual or customary arrangements requiring the entity to purchase or sell its equity securities; (3) restrictions on transferability of equity securities by the holder; (4) pool of potential buyers; (5) risk or volatility; (6) size and timing of distributions; and (7) concentration of ownership. Two types of empirical studies are often considered when estimating the potential adjustment attributable to a DLOM. The Practice Aid also discusses several quantitative methods that have been used to estimate the DLOM for privately-held securities. The studies and the quantitative methods are summarized below: Restricted Stock Studies. Transactions have historically been analyzed to assess differences between the restricted and unrestricted stock of publicly traded companies. Restricted stock is the stock of a public company that is identical to the freely traded stock of the company, except that it is restricted from trading for a certain period of time. The Practice Aid does not endorse applying discounts for lack of marketability based solely on references to these studies but instead states that each situation should be evaluated based on individual facts and circumstances. Pre-IPO Studies. These studies focus on the price a stock exhibited in a private transaction before an IPO compared to the publicly traded price subsequent to the public offering. The Practice Aid states this data may reflect a sample bias and may not accurately reflect arm s-length prices because only successful IPOs are tracked in the study, and underlying data is based on stock option grants rather than actual sales of stock. Quantitative Methods. The Practice Aid notes that estimating a discount for lack of marketability is challenging and that all of the methods have their shortcomings, namely that purchasing a put is not equivalent to purchasing marketability alone because it only limits the downside risk while leaving the upside potential. This is an area in need of further improvements and valuation professionals should be mindful of possible further developments. Of the methods used to estimate the DLOM, variations of the protective put method are the most widely used. In its simplest form, the discount is estimated as the value of an at-the-money put with a life equal to the period of the restriction, divided by the marketable stock value. Intuitively, by purchasing an at the-money put option, the buyer guarantees a price at least equal to today s stock price, thus creating liquidity. There are various applications of the 7 / Defining Issues / June 2013 / No

8 protective put model (e.g., Finnerty, Asian Protective Put, Differential Put) and the merits and shortcomings of each one is discussed in the Practice Aid. Other quantitative models include the Longstaff model and the Quantitative Marketability Discount Model (QMDM). The Practice Aid concludes that these models are not considered to be as reliable as the protective put methods when valuing minority interests in entities with complex securities. Inferring Value from Transactions in a Private Company s Securities With the developments in secondary markets, which provide a platform for trading nonpublic debt and equity securities (i.e., those not subject to public company reporting requirements), the Practice Aid provides a framework for evaluating relevancy of these trades for the purpose of valuing privately-held equity securities. The focus is on whether the secondary exchange transactions are orderly transactions, as described in ASC Topic 820. If evidence indicates the transactions are not orderly, the Guide suggests placing little, if any, weight on the exchange price. 5 The Practice Aid identifies the following factors that should be considered when determining whether to rely upon secondary market trading: Whether the Secondary Market Represents the Principal Market for the Minority Interests. The Practice Aid states that the transaction price would represent the fair value of the security if there is a transaction for an identical security on the measurement date and if the transaction takes place in an active market. Whether Secondary Market Transactions Are Orderly. Because the information about the secondary market transactions is limited, it may be difficult to determine whether these transactions are orderly. As noted in ASC paragraph J(c), these transactions may not necessarily be the sole or primary basis for measuring fair value. However, if the company is unable to conclude that the transaction is not orderly, the Practice Aid recommends giving some weight to the transaction price when measuring fair value. When determining how much weight to place on secondary market transactions, the Practice Aid recommends considering the timing of the transactions, whether there are sufficient sophisticated bidders, whether market participants have sufficient information to make an informed investment decision, the pattern of trades, and any biases or costs of holding, hedging, or trading the securities. These factors are consistent with the concepts in ASC Topic For more information see Issues In-Depth No. 12-2, Questions and Interpretative Responses for Fair Value Measurement, available at 8 / Defining Issues / June 2013 / No

9 The Practice Aid concludes that although secondary market transactions may represent observable inputs (if sufficient information about such transactions is available), they would not necessarily be the sole measure of the fair value of the securities of the entity. Recommended Disclosures In addition to the disclosures required by ASC Topic 718, the Practice Aid recommends additional disclosures for the financial statements and MD&A to be included in the registration statement for an IPO. The recommended additional disclosures are: Financial statements: For each grant date, the number of equity instruments granted, the exercise price and other key terms of the award, the fair value of the common stock at the date of grant, and the intrinsic value, if any, for the equity instruments granted (the equity instruments may be aggregated by month or quarter and the information presented as weighted-average per share amounts). Whether the valuation used to determine the fair value of the equity instruments was contemporaneous or retrospective. MD&A: A discussion of the significant factors, assumptions, and valuation techniques used in estimating the fair value of the securities. With respect to assumptions, they are often highly correlated, and therefore, it may not be helpful to disclose just one or two of the assumptions. A discussion of each significant factor contributing to the difference between the fair value as of the date of each grant and the estimated IPO price. These disclosures would generally include significant intervening events and reasons for changes in assumptions as well as the weighting of expected outcomes and selection of valuation techniques employed. The disclosures would generally be made each period in which fair value was estimated. In the past, the SEC staff has cited the examples in the 2004 version of the Practice Aid in its comment letters on initial registration statements and it seems likely this practice will continue considering the incremental disclosure recommendations made in the revised Practice Aid. Contact us: This is a publication of KPMG s Department of Professional Practice Contributing authors: Mark J. Barrysmith Peter F. Lyster Veronica Tzu-Chi Lin Earlier editions are available at: The descriptive and summary statements in this newsletter are not intended to be a substitute for the potential requirements of the Practice Aid or any other potential or applicable requirements of the accounting literature or SEC regulations. Companies applying U.S. GAAP or filing with the SEC should apply the texts of the relevant laws, regulations, and accounting requirements, consider their particular circumstances, and consult their accounting and legal advisors. Defining Issues is a registered trademark of KPMG LLP KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative ( KPMG International ), a Swiss entity.

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