In theory, the prospect of listing a company’s assets and liabilities is a fairly straightforward proposition. Businesses purchase equipment and inventory, invest in intangible assets such as brand development and goodwill, and hold hard assets such as cash. In reality, though, the value of assets can fluctuate constantly. This is especially true of investments in securities, such as stocks and bonds.
If you consider valuation of these types of assets, you will encounter a spectrum of liquidity that can render it difficult or easy to assess current market value of the security. Listed stocks traded on a major exchange are generally highly liquid, and you can determine their fair market value easily at any given time. Equity shares in privately held companies, in contrast, can be somewhat challenging to assess.
409A valuation is an independent appraisal of the fair market value performed by an outside party on behalf of unlisted or private companies and startups that offer stock options to key employees. The insightsoftware team offers a valuation service that calculates fair value for private companies.
In 2018, the Financial Accounting Standards Board (FASB) simplified many of the questions surrounding the valuation of such assets and liabilities by issuing ASC 820, also known as the Fair Value Measurements and Shareholding Disclosure. ASC 820 was incorporated into US Generally Accepted Accounting Principles (US GAAP), and went into effect for all entities for fiscal years beginning after December 15, 2019.
ASC 820 Fair Value Definition
At its heart, ASC 820 fair value measurement simply requires that you report assets and liabilities at their fair market value. It goes on, however, to provide details regarding methods for valuing various assets based on their levels of liquidity. Highly liquid assets and liabilities have an easily determinable value, whereas low-liquidity assets present more of a challenge.
In the context of ASC 820, much of the conversation is usually focused on asset valuation. It is important to recognize, however, that this standard also applies to liabilities, that is, to determine the price that would be paid to transfer a liability at fair value
ASC 820 divides assets and liabilities broadly into three categories or “levels”:
- Level 1 assets and liabilities are the most liquid. This includes things like money-market funds and stocks publicly traded on major exchanges such as the NYSE or NASDAQ.
- Level 2 assets and liabilities are not as easily priced, but you can generally measure their value using available data, including the market prices of other assets or derivatives such as interest rate swaps.
- Level 3 assets and liabilities are highly illiquid, and there generally is no readily available market data to determine their value. These may include certain foreign stocks and derivatives, but very often, a level 3 asset might be equity shares or preferred stock in a company backed by private equity or venture capital investors.
Although it’s relatively easy to determine the fair market value for level 1 and level 2 assets, level 3 presents something of a challenge. In mid-2019, the American Institute of Certified Public Accountants (AICPA) released guidance outlining best practices for valuing a level 3 asset. The AICPA typically provides such guidance to conform to US-GAAP standards, but in this case, the AICPA wrote its guidance pertaining to ASC 820 to conform to both GAAP and IFRS (International Financial Reporting Standards).
ASC 820 Valuation Methods
Generally speaking, there are two major steps in the process of ASC 820 valuation for a level 3 asset:
Step 1 is to calculate the overall value of the company in which the asset represents an investment. There are three fundamental approaches to this step in the process:
- The income approach applies a discounted cash flow or capitalized cash flow analysis to estimate the net present value of cash flows that a company is expected to generate in the future. This can be appropriate for valuing businesses that are in the later stages of their lifecycle as a private company. It generally works well if the business has established itself and is routinely generating positive cash flow or is at least approaching profitability.
- The market approach looks at general market conditions to arrive at a valuation based on similar companies and/or the most recent round of funding that the business has received. The guideline public company (GPC) method looks for publicly traded companies that are comparable in terms of size, revenue, and target market and backs into a valuation by applying multiples or divisors to the value of the public company, to arrive at a value for the business in question. The guideline transaction method looks at recent M&A activity for comparable companies and like GPC, backs into a valuation for the target company by applying multipliers or divisors to adjust for differences in size and revenue. The post-money valuation method looks to the company’s most recent round of equity financing as the primary benchmark of value.
- The asset approach simply looks to the net assets of a company to determine value. This approach may be most appropriate for very early stage companies with little or no track record of generating revenue.
Step 2 in the process is to allocate the resulting value across all share classes for the company. Again, there are multiple potential methods for accomplishing this. One popular option is the waterfall method, which is a relatively complex process that accounts for required differences in shareholder rights, including differences in the distribution of cash flows arising from liquidity events. You can use this method when a company has an especially complex capitalization table, or if there is a reasonable likelihood that the company will be acquired in the near future. Other options for allocating value include the option pricing model (OPM), common stock equivalent (CSE), and probability weighted expected return method (PWERM). Each of these has its advantages and disadvantages, depending on the complexity of the capital structure and the near-term likelihood of acquisition.
Getting ASC Fair Value Measurement Right
ASC 820 brings clarity to the process of valuing assets and liabilities, particularly in the case of highly illiquid investments. Nevertheless, the process can be tricky, especially if capitalization structures are even slightly complicated.
Early-stage companies often attempt to manage cap tables and equity-related information manually using spreadsheets. Unfortunately, that can be a cumbersome process, and is almost certain to introduce errors at some stage along the way. Instead, companies should look to equity management software purpose-built for the job and should consider engaging with a team of experts to assist with the process.
Certent, now part of insightsoftware, offers world-class equity management software and administration services for public and private companies. Whether you are looking for software to manage the process or to outsource equity compensation services altogether, we would love to meet with you and discuss your needs. Contact us today for a free demo.