Last week, guest author Corey Rosen of the NCEO started a two-part series on how companies can share equity and stay private. This week, he concludes the series.
Yes, You Can Share Equity and Stay Private: Part Two
By Corey Rosen, National Center for Employee Ownership
In Part One of this article, we looked at general issues for staying private, including plan design and redemptions. Below are four more liquidity options.
Sales to Employees
Employees can buy shares from sellers. The purchase is with after-tax dollars; the proceeds are taxed as a capital gain. Some companies pay employees a bonus to use to buy the shares or loan the money at a reasonable rate, which right now could be very low without incurring a tax problem. It is also possible to set up an internal stock market. The details are beyond the scope of this article. Suffice it to say here that the SEC has made it possible to do this is a way that avoids most significant regulatory burdens.
Outside Investors
We have seen a growing trend in recent years for investors in private companies, whether angel investors or private equity firms, to be willing to invest in closely held companied with the intention of selling to another investor group in 5-7 years instead of forcing a sale to another company. This lets the company stay private, but be aware that these investors may want some level of control even for a minority interest, preferred stock, and/or a relatively high rate of return on their money.
Secondary Markets
If your company is a high-flyer with real prospects to go public at some point, there are now secondary markets such as NASDAQ’s SecondMarket and SharesPost,that allow investors to buy equity (usually equity held by employees in the form of options or restricted shares). These rights are then traded on the market until a liquidity event. Only the most promising companies can do this, however.
ESOPs
Employee Stock Ownership Plans (ESOPs) are highly tax-favored ways for companies to redeem their own shares by setting up an employee benefit trust similar to profit sharing or 401(k) trusts that are designed to hold company stock. Companies can use pretax money to redeem the shares through the ESOP, which then allocates them to employees. All full-time employees with a year or more of service are included and allocations are based on relative pay or a more level formula. Sellers can defer capital gains tax on the sale, and S corporation ESOPs can reduce their tax obligation by the percentage of shares the ESOP owns.
Corey Rosen, Ph.D., is the cofounder and senior staff member of the NCEO. He co-authored, along with John Case and Martin Staubus, Equity: Why Employee Ownership Is Good for Business (Harvard Business School Press, May 2005). Over the years, he has written, edited, or contributed to dozens of books, articles and research papers on employee ownership. He is generally regarded as the leading expert on employee ownership in the world.
I was planning to blog more about ASU 2016-09 this week, but the FASB’s Private Company Council discussed accounting for awards granted to nonemployees at their meeting on Tuesday, so I’ve decided to blog about that instead. While the changes the FASB is considering in this area may have their genesis in simplifying things for private companies, they ultimately would apply to both private and public companies, so it’s worth reading about the meeting even for public companies.
What the Heck is the PCC?
The Private Company Council is the primary advisory body to the FASB on private company matters.
Good News
There were two bits of good news. The first is that the FASB staff recommends aligning the treatment of awards granted to nonemployees with the treatment of employee awards. Moreover, their recommendation is for awards to all nonemployees, not just nonemployees providing similar services as employees (which the staff seemed to recognize would be a bit of a rat’s nest to figure out).
Secondly, overall, the PCC generally seemed to agree with the staff’s recommendation. That’s certainly the official position. From the “Media Meeting Recap“:
The PCC generally supported aligning the models for nonemployee and employee share-based payments under GAAP.
Stuff I Found Surprising/Concerning
When I listen to FASB meetings, I often end up shouting at my computer like I am watching a televised sporting event. Here are a few things that got a reaction from me.
I was a little surprised at how unfamiliar the PCC seemed to be with how start-ups use equity awards for nonemployees. One Council member suggested that it seemed to him that accounting for employee awards is harder than accounting for nonemployee awards. For a minute there, I thought he was going to suggest that the treatment of employee awards be aligned with that of nonemployees. Luckily, most of the other Council members did not seem to agree with him.
The Council also was very concerned about companies buying goods (the example tossed about was buildings) with stock. Does this actually happen? Enough that the PCC needs to be so worried about it? I will admit that buying a building with stock is far outside my wheelhouse, so maybe it does happen all the time and maybe there are all sorts of valid concerns over how the transaction is accounted for that justify keeping this situation outside the scope of ASC 718.
Another thing I didn’t know is that the current guidance on accounting for nonemployee awards stipulates that if vesting is contingent on performance conditions, the interim estimates of expense are based on the lowest possible aggregate fair value, which is $0 if the award will be forfeited in full if the performance conditions aren’t met. 1) Who knew? 2) Are companies actually granting performance awards to nonemployees?
The Most Surprising Thing
Only one member of the PCC is located west of the Mississippi, which explains A LOT. (And, in general, all of the FASB advisory groups seem to be heavily weighted towards the east coast, which explains even more.) The one Council member from the west coast is from Portland. Nothing against Portland, but given the proliferation of start-ups here in Silicon Valley, it seems like maybe the FASB ought to find an accounting practitioner from this area who works with starts-up to be on the Council. Equity compensation can’t be the only area where technology start-ups do things differently.
Today’s blog features guest author Corey Rosen of the NCEO on how companies can share equity and stay private.
Yes, You Can Share Equity and Stay Private: Part One
By Corey Rosen, Founder, National Center for Employee Ownership
Recent reports show that more and more entrepreneurial companies are choosing to stay private for much longer periods of time. That may be because they do not believe the IPO market is ripe for an offering, or that they realize that the chances of actually having an IPO for most start-ups is comparable to high school basketball players making the pros. Some companies could find another company to buy them, but may not find the terms attractive. Still other entrepreneurs just don’t want to give up control. They may like what they do or, increasingly, have a social purpose that they believe the buyer will undermine.
Many of these companies share equity with employees, but wonder about how that can become liquid. Some are reluctant to spread equity too widely for just this reason, even though they like the idea of employee ownership.
In fact, there are lots of practical ways to share equity, stay private, and provide liquidity. In this two-part series, I look at how to do that. The National Center for Employee Ownership’s Staying Private: Liquidity Options for Entrepreneurial Companies, provides a detailed examination of these issues.
Design Your Plan with Liquidity in Mind
Many entrepreneurs I talk to say that equity stakes will become liquid when there is a liquidity event, but they don’t know when, if, or how that will occur. To them, this is not a big issue—they plan to stay until that happens and maybe beyond. But for employees, the uncertainty makes equity grants far less valuable than they really are because, as we know from behavioral economics research, people vastly overweight risk and uncertainty in assessing economic value. On top of that, some plans may have grants that expire if not exercised, but if they are exercised, employees have to pay a tax now for a benefit that can’t be realized any time soon.
To deal with this problem, companies should consider vesting on liquidity only. If liquidity is too far away and too uncertain, they should look for ways to provide liquidity in the interim, as described below. Companies can limit the cash drain of these approaches by using net settlements, where the employees get the net after tax value of the equity holdings on exercise in the form of shares. That way, at least employees aren’t paying out of pocket, something that makes the award look like punishment.
Second, you need a realistic way to assess value. Formula approaches like book value and multiples of revenues are frequently used and almost invariably wrong. A basic valuation by an outside appraiser is not very expensive and is well worth the several thousand dollar cost. It gives your plan a lot more credibility, it assures that you are paying an appropriate amount, and gives you a good sense of how your company can become more valuable.
So how can you provide liquidity?
Redemptions
The simplest approach is for the company to buy back the stock. This must be done with after-tax dollars. Equity holders who paid for their shares get capital gains treatment on the sale if they are effectively exiting the business; otherwise, dividend rates apply. Currently, there is little difference between the two, however, unless the owner has a substantial basis in the shares, in which case capital gains treatment is preferable. The shares can be retired (meaning the enterprise value of the company goes down, but the per share value of remaining shares remains the same) or made available for sale to other buyers or for awards to employees.
In part two of this article, we will look at four other alternatives: sales to employees, outside investment, secondary markets, and ESOPs.
Corey Rosen, Ph.D., is the cofounder and senior staff member of the NCEO. He co-authored, along with John Case and Martin Staubus, Equity: Why Employee Ownership Is Good for Business (Harvard Business School Press, May 2005). Over the years, he has written, edited, or contributed to dozens of books, articles and research papers on employee ownership. He is generally regarded as the leading expert on employee ownership in the world.
For my last installment (at least for the moment—expect another blog when the FASB officially adopts the new standard) in my series on the FASB’s ASC 718 simplification project, I answer a few questions relating to early adoption of the new standard.
Can companies adopt it early?
Yes, companies can adopt the amended standard in any interim or annual period after the FASB approves the official amendment. If the FASB approves the amendment as expected in this quarter, companies could adopt it in this quarter.
Can companies adopt it now?
No, not quite yet. Companies have to wait until the final amendment is approved by the FASB to adopt it.
Can companies adopt just the parts of the update they like early and wait to adopt the rest of it?
Heck no! This isn’t a salad bar; it’s all or nothing. You have to take the bad with the good.
If we start allowing employees to use shares to cover tax payments in excess of the minimum required withholding now, are my auditors really going to make me use liability accounting, given that we all know the rules are changing soon?
Well, I can’t really speak for your auditors, so you’d have to ask them—accounting-types do tend to be sticklers for the rules, however. If the FASB approves the amendment on time, you could adopt it this quarter and there’d be no question about liability treatment. But you’d have to adopt the whole standard, including the tax accounting provisions, so you would want to make sure you are prepared to do that.
If you don’t want to adopt the entire update as soon as the FASB approves it, liability treatment applies if shares are withheld for more than the minimum tax payment. For awards that are still outstanding when you adopt the update, this liability treatment will go away. You’ll record a cumulative adjustment at the time of adoption (see my blog last week on the transition) to switch over to equity treatment. But for the awards that are settled prior to when you adopt the standard, you won’t reverse the expense you recognize as a result of the liability treatment.
If the awards that will settle between now and when you expect to adopt the standard are few enough, the expense resulting from the liability treatment might be immaterial. Likewise, if your stock price is at or below the FMV back when the awards were granted, you might not be concerned about liability treatment because it likely wouldn’t result in any additional expense.
Note, however, that if you establish a pattern of allowing share withholding for excess tax payments, liability treatment applies to all awards, not just those for which you allow excess withholding. You could have liability treatment for all award settlements that occur before you adopt the amended standard.
For today’s installment in my series on the FASB’s ASC 718 simplification project, I explain what the next steps are in this process.
Is the update final now?
Not quite yet. For the most part, we know what the final update is going to look like because the FASB’s decisions with respect to each issue in the exposure draft are public. But the FASB staff still has to draft the actual amendment to ASC 718 and the FASB has to vote to adopt the amendment.
In addition, there are a few technical details in the exposure draft that were commented on and that we expect the staff to clean up, but we won’t know for sure until the amendment is issued. The FASB didn’t vote on these details because they don’t change the board’s overall position; it is merely a matter of clarifying what the board’s decision means with respect to some aspects of practical implementation. For example, the language of the proposed amendment relating to share withholding seemed to imply something different than the FASB’s explanation of what this change would be. I am assuming the staff will modify this language but we won’t know for sure until the final amendment is issued.
When will the FASB adopt the amendment?
According to the FASB’s Technical Agenda, this project is expected to be finalized in Q1 2016. Anyone who’s been in the industry for a more than a couple years knows, however, that these things tend to slip a bit. In my 20 years in this industry, I can’t think of a single regulation, rule, amendment, etc. that, when targeted for issuance during a specific time frame, came out earlier than the very last week or so in that time frame. (10 pts to anyone who can prove me wrong on this—I started in the industry in 1994, so stuff before that doesn’t count.) The FASB is no exception, so I’m guessing that we are looking at the end of March or maybe even Q2 2016.
When will companies be required to comply with the new guidance?
Public companies will have to adopt the update by their first fiscal year beginning after December 15, 2016 (and in the interim periods for that year). Private companies have a year longer to adopt for their annual period and two years longer for interim periods.
Will the standard now be called ASC 718(R)?
No. For people like me who write about accounting, that would be handy because it would make it easy to distinguish when I’m talking about the pre-amendment vs. the post-amendment ASC 718. Now I’ll have to use some sort of unwieldy clarification, like “ASC 718, as amended in 2016.” But under the FASB’s codification system, the existing standard is simply updated to incorporate the amendments. The name of the standard will stay the same.
If the Codification system didn’t exist, maybe we would call it FAS 123(R)(R). Or would it be FAS 123(R)2?
For my first blog entry of 2016, I look at the transition methods that will apply under the FASB’s Accounting Standards Update (ASU) to ASC 718. (If you’ve forgotten what this is all about, read Part I and Part II of my update on the FASB’s decisions on the ASC 718 simplification project.) Also, see my handy chart showing how FASB voted on each issue in the exposure draft and the required transition method for it.
Prospective
The prospective transition method is perhaps the easiest to understand. Under this method, the company just changes its accounting procedures on a go-forward basis, with no restatement of prior periods or cumulative adjustments.
The prospective transition method will be used for the tax accounting provisions. For transactions that occur after a company adopts the ASU, the amounts that would have been recorded to additional paid-in capital will now simply be recorded to tax expense. It’s that easy: no adjustments to paid-in capital or tax expense for past transactions and the ASC 718 APIC pool calculation is no more.
Retrospective
Retrospective transition is also fairly straightforward. With this method, the company changes its accounting procedures going forward, but also adjusts any prior periods reported in its current financials. For example, most companies show three fiscal years in their annual financial statements. Where retrospective transition is required, a company that adopts the ASU in 2016 would not only change their accounting procedures for 2016, but would go back and adjust the 2015 and 2014 periods as if the new rules had applied in those periods.
The adjustment is presented only in the current financials; the company does not reissue any previously issued financial statements or re-file them with the SEC.
The only provisions in the ASU that are subject to retrospective transition are the provisions related to classification of amounts reported in the cash flow statement (and for the classification of excess tax benefits, the company can choose between prospective and retrospective).
Modified Retrospective
This transition method is used when a cumulative adjustment is necessary. Accounting for forfeitures is a good example. A company can’t just switch from applying an estimated forfeiture rate to accounting for forfeitures as they occur on a prospective basis: since previously recorded expense was adjusted based on estimated forfeitures, companies would end up double-counting forfeitures when they occur. Retrospective restatement wouldn’t fix this problem because some of the prior expense may have been recorded outside of the periods presented in the company’s current financials.
It also doesn’t make sense to make companies record a big change in expense in their current period; this would be confusing (and possibly alarming) to investors and isn’t reflective of what is happening. So instead, the transition is handled with a cumulative adjustment that is recorded as of the start of the fiscal period. This adjustment is recorded in retained earnings (which is the balance sheet account where net earnings end up) with an offsetting entry to paid-in capital.
In the case of forfeitures, the company calculates the total expense it would have recognized as of the start of the period if it had been accounting for forfeitures as they occur all along and compares this to the actual amount of expense recorded to date (which should generally be lower). The difference is then deducted from retained earnings, with a commensurate increase to paid-in capital.
In addition to the forfeitures provision, modified retrospective is used for private companies that take advantage of the opportunity to change how they account for liability awards. It is also used theoretically for the share withholding provisions if companies have been allowing employees to tender shares in payment of taxes in excess the minimum statutorily required withholding and has outstanding awards that are subject to liability treatment as a result. But I doubt anyone has been doing that, so in practice, I don’t think a transition will be necessary for the share withholding provisions.
This week I provide additional coverage of the decisions the FASB made on the ASC 718 simplification project (see my blog from last week for Part 1).
Cash Flow Statement
The Board affirmed both of the proposals related to the cash flow statement: cash flows related to excess tax benefits will be reported as an operating activity and cash outflow as a result of share withholding will be reported as a financing activity. Nothing particularly exciting about either of these decisions but, hey, now you know.
Repurchase Features
The board decided not to go forward with the proposal on repurchases that are contingent on an event within the employee’s control. The proposal would have allowed equity treatment until the event becomes probable of occurring (which would align with the treatment of repurchases where the event is outside the employee’s control). The Board decided to reconsider this as part of a future project. The Board noted that this would have required the company to assess whether or not employees are likely to take whatever action would trigger the repurchase obligation, which might not be so simple to figure out (we all know how hard it is to predict/explain employee behavior).
Practical Expedient for Private Companies
The Board affirmed the decision to provide a simplified approach to determining expected term for private companies, but modified it to allow the approach to be used for performance awards with an explicitly stated performance period. I’m not sure that many private companies are granting performance-based stock options, but the few who are will be relieved about this, I’m sure.
Options Exercisable for an Extended Period After Termination
Companies that provide an extended period to exercise stock options after retirement, disability, death, etc., will be relieved to know that the FASB affirmed its decision to eliminate the requirement that these options should be subject to other applicable GAAP. This requirement was indefinitely deferred, but now we don’t have to worry about it at all.
This is the most controversial aspect of the exposure draft. The volatility that this change introduces to the P&L is likely to be significant for companies that rely heavily on stock compensation. We performed a very quick analysis of a handful of companies and found that, for several of them, recognizing excess tax benefits in their P&L would have increased EPS by 10%. In one case, EPS increased by 60%. Ultimately, we think this will be incredibly confusing to investors and other financial statement users. We also feel that it is highly unintuitive for changes in a company’s stock price to generate significant profits and losses for the company. While eliminating the ASC 718 APIC pool is very attractive, ultimately, we felt that the impact on earnings and effective tax rates would offset the benefits of simplifying this area of the standard. Because of this, we recommended against this amendment.
We suggested that companies record all excess tax benefits and shortfalls to paid-in capital, rather than tax expense. This would eliminate the need to track the APIC pool without impacting the P&L.
Forfeitures
We supported the proposal to allow companies to make a policy election to account for forfeitures as they occur. Our only comment on this topic was to suggest that the FASB provide a mechanism for companies to change their election without treating it as a change in accounting principle (which requires a preferability assessment and retrospective restatement).
Share Withholding
We supported the proposal to amend the standard to provide that shares can be withheld to cover taxes up to the maximum individual tax rate without triggering liability treatment.
We asked the FASB to provide additional guidance on how this requirement applies to mobile employees and suggested that share withholding be allowed up to the combined maximum tax rate in all jurisdictions that the transaction is subject to.
We also asked the FASB to remove the requirement that the tax withholding be mandated by law.
Practical Expedient to Expected Term
We supported allowing private companies to treat the midpoint of the vesting period and contractual term of an option as the option’s expected term for valuation purposes. We asked the FASB to remove the condition that the option be exercisable for only a short period of time after termination of employment and also requested removal of the conditions applicable to performance-based options.
The Rest of It and Thanks
We supported the remaining proposals in the exposure draft without comment.
Thanks to everyone that completed the NASPP’s quick survey on the exposure draft—I hope to have the results posted by the end of this week.
Thanks also to individuals who agreed to serve on our task force for this project: Terry Adamson of Aon Hewitt, Dee Crosby of the CEP Institute, Elizabeth Dodge of SOS, Sean Kelly of Morgan Stanley, Ken Stoler of PwC, Sean Waters of Fidelity, Thomas Welk of Cooley, and Jason Zellmer of Bank of America Merrill Lynch. Their help was invaluable.
Last week, I blogged that the FASB has issued the exposure draft of the proposed amendments to ASC 718. In this week’s blog entry, I cover some of the additional issues addressed by the amendments.
Cash Flow Statement
The proposed amendments suggest changes to how a couple of items should be categorized in the cash flow statement. Most significantly, excess tax benefits realized from stock plan transactions would be presented as an operating activity. Currently, excess tax benefits are reported twice in the cash statement: as a cash inflow in the financing activities and a cash outflow in operating activities. In her “Meet the Speaker interview” last summer, Ellie Kehmeier highlighted the failure to do this as a very common error that companies make, so this change will clearly be helpful.
Private Companies
It is often very difficult for private companies to estimate the expected term of option grants. To assist with this, the proposed amendments would allow private companies to use a method similar to simplified method allowed under SABs 107 and 110. I think a lot of private companies are already doing this, so I’m not sure how revelatory this is. Also, the FASB imposes the same limitations that the SEC does, (i.e., the approach can only be used for options that are exercisable for only a short time after termination of employment), making this somewhat less than helpful.
The FASB is also under the impression that there are a bunch of private companies with liability awards that did not know that they could have elected to value these awards using the intrinsic value method back when they adopted the standard and are now stuck with using the fair value method for them. The proposed amendments would give these companies a one-time opportunity to change the measurement of liability awards from fair value to intrinsic value without having to justify the change.
I don’t encounter a lot of liability awards at either public or private companies, so I am skeptical about how helpful this is, but maybe there are a bunch private companies that just cannot wait to change over to the intrinsic value method for their liability awards. Assuming they are paying attention and don’t miss this opportunity. Considering that they apparently already missed the opportunity once, I’m not optimistic. Are we going to have to go through this all again in another ten years? Maybe the FASB should just give private companies a free pass on changing the valuation method for liability awards once every ten years so we don’t have to discuss this again.
FSP FAS 123(R)-2
In somewhat more exciting news, the amendments would make permanent the guidance in FSP FAS 123(R)-2. This means that we no longer have to worry that, in the future, options that are exercisable for an extended period of time after termination of employment will be subject to liability treatment. I know you probably had forgotten that this was even a possibility, but it’s something I’ve been thinking about as I see FASB alerts that seem to indicate that the FASB is making progress on the other projects that would have impacted this. Now we all have one less thing to worry about. I also think this might be a sign that the FASB may eventually allow awards to non-employees to receive the same treatment as awards to employees—how awesome would that be!
For today’s blog entry, I have a grab bag of topics, but with a theme–all of the topics are interesting things pre-IPO companies (or their employees) have done lately.
Pinterest Extends Post-Termination Exercise Period Pinterest recently announced that they are going to extend the post-termination exercise period from the traditional 30-90 days to seven years, for employees that have been with the company for at least two years. We discussed this development in the May-June 2015 Advisor, with a link to an article in Fortune (with the somewhat misleading title of “Pinterest Unpins Employee Tax Bills“).
Most companies don’t do this because allowing terminated employees longer to exercise potentially takes shares away from current employees, who are still contributing to the company. This can also be an administrative challenge, since the company could end up having to process exercises (and withhold taxes and report income) for employees that have been gone for up to seven years. Not to mention, it’s hard to keep track of terminated employees for seven years. (Then again, Pinterest is located in San Francisco. With the median rent upwards of $3,000 for a one-bedroom and with rent control, maybe it won’t be so hard for them to keep track of their employees. Who can afford to move before their options pay out?)
Pinterest Facilitates Sales for Employees Another interesting thing Pinterest is doing is allowing employees to sell some of their vested stock to the company’s external investors (see “Pinterest Adds $186 Million to Series G Round, Lets Employees Sell Shares” in Re/Code). This will enable Pinterest employees to realize a return on some of their stock before the company goes public. Usually when private companies want to allow employees to liquidate, they implement a repurchase program. Allowing employees to sell stock to outside investors is somewhat novel.
Presumably there is a limit on the size of investment Pinterest’s external investors are willing to make in the company, so allowing employees to sell stock to their investors potentially means less capital is available to Pinterest. But internal repurchase programs require the company to come up with the cash and can trigger additional compensation cost under ASC 718. Pinterest may feel this is preferable to allowing employees to sell shares in the secondary markets, where Pinterest would have no control over who buys the stock.
Stock Options for Houses While we’re on the subject of the crazy real estate market in San Francisco, I recently came across an article about people including stock options in bids to purchase houses: “Desperate Local Home Buyers Now Bidding With Stock Options.” The article says the tax consequences are too complicated to make it worthwhile. I am sure they are right about that, nevermind the valuation issues.
Stock Options for Customers Jet.com is taking a different tactic. In November of last year, they announced a contest in which subscribers competed to receive a stock option by referring other people to the website. The overall winner got an option for 100,000 shares and the next top ten finishers got an option for 10,000 shares. The winner spent about $18,000 to generate about 8,000 new subscriptions to Jet.com (see “How This CEO Hustled His Way to an Equity Stake in Jet.com” and “What’s It Take to Challenge Amazon? For Jet.com, Giving Away Equity to Lure New Users“).
I’m sure this idea is a rabbit hole of complex legal issues, not the least of which is, are participants in a contest like this considered service providers and are the options compensation? Or are the options treated like some sort of prize/gambling winnings? Ten points to anyone who figures this out.
Corey Rosen, Ph.D., is the cofounder and senior staff member of the NCEO. He co-authored, along with John Case and Martin Staubus, Equity: Why Employee Ownership Is Good for Business (Harvard Business School Press, May 2005). Over the years, he has written, edited, or contributed to dozens of books, articles and research papers on employee ownership. He is generally regarded as the leading expert on employee ownership in the world.