Common Private Company Equity Transactions

Private companies often have complex equity transactions due to the nature of private company funding. As a result, even seasoned accountants can find accounting for equity incentives, share repurchases, preferred stock, and profit interest awards confounding from time to time.

With that in mind, here are a few routine equity transactions that private companies need to pay close attention to, as well as what to look for when encountering these transactions.

Equity Incentive Plans

Equity incentive plans provide for the issuance of incentive stock options and are a popular component of overall compensation. The value of the award is dependent on the value of the underlying equity in the company.

There are several methods for computing the fair value of incentive stock option awards; the most common method is the Black-Scholes option pricing model. This method assumes that returns on the company’s shares follow a normal distribution. Volatility, a measure of the amount of uncertainty over future share price returns, is the standard deviation of this distribution. The Black-Scholes model also takes into account the risk-free interest rate and dividends paid to shareholders.

The mathematics involved in calculating the Black-Scholes model is complicated. Fortunately, modern computing power makes this method accessible with a Black-Scholes Calculator, which can be found online.

Common Stock Share Repurchases

A company may decide to purchase its own stock for a number of reasons. The shares repurchased can be used for future issuances, employee compensation, or can be retired upon repurchase, which reduces the company’s market capitalization.

When repurchasing shares from common stockholders, it’s important to determine whether the repurchase price is greater than the current fair market value of the shares. It’s also important to know whether the shares will be retired or canceled upon repurchase. The share repurchase price and dispositions affects how the repurchase is recorded in equity: as treasury stock, additional paid-in capital (APIC), or expense.

For example, if the shares are purchased from an employee at an amount greater than the fair value of the shares at the time of the transaction, the excess purchase price is considered employee compensation.

Preferred Stock

Companies may issue both common stock and preferred stock. Although preferred stock also represents ownership, it differs from common stock because it carries preferential terms. Preferred stock is recorded at the preferred stock class price. 

To determine each class of preferred stock’s carrying value, the first step is to determine whether the preferred stock is redeemable, convertible, and/or subject to cumulative dividends. Redeemable preferred stock allows the holder to put the shares back to the company after a specified date and upon the vote of the holders. Convertible preferred stock allows the holder to convert their shares into a set number of common shares upon a certain event or at the option of the holder.

Cumulative preferred stock would pay cumulative dividends if a dividend payment were missed. Because redeemable preferred stock will obligate the company to pay cumulative dividends upon redemption, cumulative dividends should be recorded in the statement of equity so that the shares are accreted to their redemption value. The offset to the increase in preferred stock carrying value generally goes to retained earnings, consistent with declared dividends.

If preferred stock is not redeemable, but dividends are cumulative, the company needs to track and disclose the cumulative dividends in its financial statements. However, dividends are not recorded in the statement of equity until the dividends are declared.

Issuance costs for redeemable preferred stock are initially recorded as an offset to the preferred stock class issuance value and accreted from issuance to the first date of redemption.

Profit Interest Awards

Equity Transactions

Profit interests are a special form of equity compensation issued by limited liability companies (LLCs). They provide a share of future “profit” in the company and are used as an incentive to attract, retain, and reward employees. These can be classified as share-based payments, profit-sharing, bonus arrangements, or deferred compensation, depending on the terms and features of the awards. Typically, the fair value of the award must be recorded as an operating expense over the vesting period.

Although there are many methods for determining the fair value of profit interest awards, the most reliable one is based on reasonably possible cash flow scenarios, which would result in distributions to the profit interest’s holders. One option is a Monte Carlo simulation model, which can be used when profits interests receive value after a specific future event has occurred. For example, that event might be reaching a threshold return on investment or multiple on invested capital. These simulation models incorporate uncertainty and various market factors through multiple iterations to see how uncertainty affects the expected equity value.

Another option is to use the Black-Scholes model to calculate fair value, after performing a valuation of the company as a whole and waterfalling the company value to each class of equity.

How Holtzman Can Help

With so many factors affecting the valuation of and accounting for equity transactions, it can be a daunting task to ensure the transactions are accurately recorded in the financial statements. If you need a trusted advisor to assist in properly valuing all types of equity transactions, reach out to our Audit & Assurance team.

Service expansion announcement: Holtzman is becoming Armanino effective January 1, 2022.

By joining together, Holtzman clients will have access to an expanded suite of accounting and consulting offerings to support any stage of company growth. Armanino’s Tax practice, with its deep bench, can provide on-demand expertise on a multitude of issues, including international tax, state and local tax, transfer pricing, R&D tax credits, transaction advisory, provision, estate and trust, partnerships and qualified business income. Learn more in our press release.

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