Accounting for equity-based compensation presents various challenges specific to each company, its capital structure and its option types.
For closely held businesses, compliance with ASC 718 and IRC §409A may require up to three components:
- Valuation of the overall equity of the business;
- Allocation of the total value to the various classes of equity; &
- Valuation of the option itself (if necessary).
Allocation of the total value to the various classes of equity:
There are various methods of allocating a company’s value to the various components of its capital structure which are described in the American Institute of Certified Public Accounts’ (‘AICPA’) Accounting and Valuation guide, Valuation of Privately-Held-Company Securities as Compensation (the ‘Practice Aid’).
Determination of base price for Stock Appreciation Rights to be issued to the top management of the company. Two classes of equity shares with deferring rights and preferences gave rise to complication on the allocation of value to each class of equity share.
- Value the total equity of the business using appropriate methods, whether the traditional cost, market and income approaches, or unique techniques used to value companies;
- Analyzed the stock appreciation rights agreement to understand the rights and preferences pertaining to equity security being issued and the outcome of each potential exit event to be pursued by the company;
- Determination of inputs to be used for the option valuation methods (value of underlying asset, exercise price, volatility if underlying asset, time of expiration, dividend rate and risk free rate) from industry databases and client discussions; &
- Thereafter, using Black Scholes option pricing model, the total value was allocated amongst various classes to determine the SAR value as per method described in the AICPA Practice Aid.
- Binomial option pricing model was also employed to corroborate and confirm the analysis done using the Black Scholes model. Use of binomial model also facilitated management’s understanding, enabling them to visualize the changes in equity value at different points in time;
- Provided scenario analyses for the management to assist them in understanding the impact of each potential exit event on the value of the SAR’s;
- Provided comprehensive explanatory memo along with various rounds of discussion with the controller and the management enabling them to get a holistic view of the financial impact of the SAR’s; &
- Additionally, assisted the client in drafting of the final agreement to ensure the desired outcome is aligned with the intended objectives on the management.
The approach and methodology was vetted by the client’s external advisor and was accepted without any changes. Our assistance and expertise were appreciated by the client.