Equity compensation in a privately owned company: How to comply with valuation requirements
A publicly traded company can easily get this information from the market. By contrast, a privately owned company must prepare an analysis or use the services of a valuation firm. The problem? It’s just not practical to value a privately owned company every day.
How a privately owned company can comply
Fortunately, there are guidelines that make things easier for a privately owned company to satisfy valuation requirements for equity compensation.
The first thing to understand is that value is as of a specific date and based on what was known at that time. A value can’t use information, such as financial results or market conditions, that occur after the valuation date. What this means is a value can be used going forward but not backward.
For example, equity compensation grants made in June can usually rely on an earlier value from April of that year. However, grants made in April aren’t able to use a later value from June.
The basic rule is that a private company can continue to use a value for grants of equity compensation with a shelf life until the earliest of:
- One year
- A material event
The one-year criteria is easy to follow and works well for a privately owned company. The company sets a value, uses it for a year, and then gets an update. This one-year standard is found in tax regulations such as Internal Revenue Code 409A and U.S. generally accepted accounting principles guidance such as ASC 718.
However, an important additional condition is to consider the effect of subsequent events on value that may require an update, even if it’s been less than one year. This makes things a little more complicated.
Events that may require an update
Although there aren’t specific rules on which events might require an update, items to consider include:
- General business performance, outlook, and financial condition
- Major milestones or events in the business
- Mergers, acquisitions, and divestitures
- New equity or debt funding
- Changes in ownership structure
- Redemption of equity compensation
- Modification of existing grants
- Gifting and estate planning
- External factors such as interest rates, industry trends, economy, tax rates, or financial markets
Deciding which events prompt an update depends on facts, circumstances, and judgment. Certain events will have the need for a new value readily apparent, such as a major acquisition or new equity funding. For other situations, establishing benchmarks can be helpful.
Compliance questions: Where should you start?
A practical strategy is to look for changes most likely to impact the value of equity compensation. These will usually relate to capital structure, business performance, growth, and risk. As a very general rule of thumb, changes of around 10% or more could begin to warrant further attention.
Keep in mind these situations don’t automatically require an update. Rather, they suggest making an overall assessment of areas that impact value and exploring if these could create material changes. There are often simple analyses, estimates, or benchmarking that can be performed before deciding to undertake a full valuation analysis. Whatever the case, solutions can — and will — vary based on the circumstances. A proactive, comprehensive approach to understanding valuation requirements can help you get in front of compliance issues before you encounter them.