In August 2020, the Financial Accounting Standard Board (FASB) issued an exposure draft for a proposed accounting standards update for private companies to help determine the value of underlying common stock. Right now, companies that issue stock options have to navigate two different standards of value—with Generally Accepted Accounting Principles (GAAP) utilizing “fair value” rules, and the Internal Revenue Service (IRS) using “fair market value.” This seemingly minor distinction causes some confusion and difficulty in a company’s process to determine the value of underlying common stock, so the FASB seeks to simplify the accounting rules to make it easier for private companies to apply.
We take a look at the nuances of this proposed new rule, and analyze how it could potentially affect technology companies if approved.
Stock Options: GAAP vs. the IRS
When it comes to stock compensation, GAAP and the IRS just can’t agree. The IRS’s Internal Revenue Code (IRC) Section 409A and the GAAP’s Accounting Standards Codification (ASC) 718 both deal with stock options, but differ in their definitions and methods of determining stock value. IRC Section 409A outlines three possible methods for establishing “fair market value” for IRS purposes, while GAAP doesn’t embrace the same three methods.
IRC Section 409A & the FASB’s ASC 718
IRC Section 409A outlines the following three allowable methods that are presumed to be reasonable for establishing “fair market value”:
- A valuation determined by an independent appraisal within the 12 months preceding the grant date
- A valuation based on a formula
- A valuation made reasonably, in good faith, and evidenced by a written report that considers the relevant factors of the illiquid stock of a start-up corporation (internal valuation method)
The FASB’s proposed accounting standards update would provide a practical expedient to nonpublic companies to utilize the same three valuation methods defined in IRC Section 409A to establish a “current price” of a share underlying a stock option.
The Impact on Tech Companies
Typically, technology companies that are starting to issue stock options quickly move to the first method—obtaining an independent appraisal. This type of valuation would satisfy both the GAAP and IRS standard of value simultaneously by establishing a “fair market value” to satisfy the IRS, and establishing a “fair value” to adhere to GAAP. However, the FASB’s proposed accounting standards update theoretically opens up the other two valuation methods outlined in IRC Section 409A for use for purposes of GAAP.
So even though this new proposed standard increases the valuation methodologies available to tech companies, we don’t anticipate most companies adopting it.
Most companies are already getting a valuation to ensure compliance with the 409A rules. When going through this process, there’s almost no incremental cost or effort to have those valuations also satisfy the existing “fair value” standard of value outlined in GAAP, so there’s no heavy incentive to change the method. Also, while the new standard would allow the other two IRC methods (a valuation based on a formula, and the internal valuation method) for GAAP purposes, they aren’t very practical in many situations. So this proposed amendment isn’t expected to have a significant impact on the way tech companies estimate the value of their common stock for purposes of pricing options.
The most likely application of this proposed new standard would be very early stage tech companies with limited option granting activity taking advantage of the internal valuation method, since this method would be embraced by GAAP and the IRS.
While we commend the FASB for any attempt to simplify the accounting rules and make them easier for private companies to apply for stock options, we don’t see this proposed accounting standard making much progress in that direction.