Coming soon: New, simpler rules for private company stock options

Published August 5, 2021

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The Private Company Council (PCC) on June 22, 2021, approved the issuance of a new standard related to pricing equity-classified share option awards. The guidance will provide a simpler and less costly way for private companies to determine the fair value of employee stock options and other share-based awards at grant date or upon a modification to an award. Here are the details.

Long-standing project

Many companies award stock options and other forms of share-based payments to workers to promote exceptional performance and reduce cash outflows from employee compensation. But accounting for these payments can be confusing and time-consuming, especially for private companies.

“We’ve been working on this project for a long time,” said PCC Chair Candace Wright. “We’ve consistently heard that share-based compensation was somewhat difficult and seemed overly complex and costly from a private company perspective so that’s why the PCC decided to take this on.”

The PCC is the group that works with the Financial Accounting Standards Board (FASB) to develop and amend U.S. Generally Accepted Accounting Principles (GAAP) for private companies. Any new standards or updates recommended by the PCC are subject to FASB approval.

Book vs. tax reporting

To measure the fair value of stock options under existing GAAP, companies generally use an option-pricing model that factors in the following six variables:

  1. The option’s exercise price,
  2. The expected term (the time until the option expires),
  3. The risk-free rate (usually based on Treasury bonds),
  4. Expected dividends,
  5. Expected stock price volatility, and
  6. The value of the company’s stock on the grant date.

The first four inputs are fairly straightforward. Private companies may estimate expected stock price volatility using a comparable market-pricing index. But the value of a private company’s stock typically requires an outside appraisal. Whereas public stock prices are usually readily available, private company equity shares typically aren’t actively traded, so observable market prices for those shares or similar shares don’t exist.

To complicate matters further, employee stock options are also subject to Internal Revenue Code Section 409A. The use of two different pricing methods usually gives rise to deferred tax items on the balance sheet.

Simplification measures

The PCC’s discussions on June 22 followed up on a proposal issued a year ago. Proposed Accounting Standards Update (ASU) No. 2020-200, Compensation-Stock Compensation (Topic 718): Determining the Current Price of an Underlying Share for Equity-Classified Share-Option Awards, would apply to all equity classified awards under Accounting Standards Codification Topic 718.

The updated guidance would allow private companies to determine the current price input in accordance with the federal tax rules, thereby aligning the methodology used for book and federal income tax purposes. Sec. 409A would be referenced as an example, but the rules would also include facts and circumstances identified in Sec. 409A to consider for reasonable valuations.

The PCC discussed whether the proposed reference example to Sec. 409A of the valuation should be kept in the forthcoming standard or shifted to the “basis of conclusions” section of the document. The PCC decided to keep the example, believing it would be simpler and eliminate confusion.

“We want people to only have to look at one set of rules, do one valuation and have that be compliant with the practical expedient. I think we hit on exactly the right balance,” said PCC member Timothy Curt, former managing director of Warburg Pincus LLC.

Coming soon

The FASB is expected to issue updated guidance by year end. The rules will be effective prospectively for fiscal years on or after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Earlier application would be allowed — and many private companies that plan to issue or modify share-based payments are expected to adopt this practical expedient as soon as possible.

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