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Stock-based compensation – 5 things for private companies to know · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC's National Office.
• 0:06
  SPEAKER_02: Hello, and welcome to PWC's Accounting Podcast.
• 0:11
  SPEAKER_02: I'm Heather Horn.
• 0:13
  SPEAKER_02: In today's podcast, we focus on five things you need to know about accounting for stock-based comp awards issued by non-public companies.
• 0:21
  SPEAKER_02: This is one of the few areas in US GAP where private company accounting is actually more complex than that for public entities.
• 0:30
  SPEAKER_02: This episode gives a great glimpse into some of the unique issues in awarding stock-based comp when a company's shares are not publicly traded.
• 0:38
  SPEAKER_02: And I hope you find the discussion as interesting as I did.
• 0:42
  SPEAKER_01: And then just in general, we we see I think there's more flexibility for private companies and how they design the awards because there's just less scrutiny on their executive compensation programs.
• 0:52
  SPEAKER_01: You know, public company has proxy advisory firms, institutional investors looking at and commenting on their programs.
• 0:59
  SPEAKER_01: Private companies don't usually have that, and so there's just more flexibility for more different types of designs.
• 1:04
  SPEAKER_02: That was Ken Stoller, a partner in PWC's national office, who focuses on working with clients and engagement teams on this topic.
• 1:12
  SPEAKER_02: He's helped companies navigate their employee compensation issues during IPOs and other major transactions and events.
• 1:19
  SPEAKER_02: He brings all of his experience and knowledge to the podcast.
• 1:22
  SPEAKER_02: So let's start the episode.
• 1:29
  SPEAKER_02: Ken, welcome back to the podcast for our second episode in our two-part series talking about stock comp.
• 1:35
  SPEAKER_02: And as I mentioned last episode, we're taking a little bit different format this time and talking about our top five things you need to know about a particular topic.
• 1:44
  SPEAKER_02: And for today's episode, we're actually focused in on stock comp, specific to private companies.
• 1:50
  SPEAKER_02: So why'd you pick this topic?
• 1:52
  SPEAKER_01: Well, interestingly, when we get questions in the national office on stock compensation, the questions on private company awards tend to be the trickiest and most complicated.
• 2:04
  SPEAKER_01: I think it's for a couple of reasons.
• 2:06
  SPEAKER_01: Number one, obviously there's no public market for private company shares.
• 2:10
  SPEAKER_01: And so often the stock comp awards have to have various either cash settlement features in them or company repurchase features.
• 2:19
  SPEAKER_01: And anytime we start introducing cash mechanisms in a stock award, that can create some complexity.
• 2:26
  SPEAKER_01: Private company capital structures tend to be more complex than public companies.
• 2:30
  SPEAKER_01: We've got lots of different uh classes of equity, and employees are often receiving different classes of equity, which can add to complexity.
• 2:38
  SPEAKER_01: Uh sometimes we'll have uh vesting conditions that are tied to the returns that maybe a private equity owner of the business is getting.
• 2:47
  SPEAKER_01: And so these can make the awards a little trickier.
• 2:50
  SPEAKER_01: And then just in general, we we see I think there's more flexibility for private companies and how they design the awards because there's just less scrutiny on their executive compensation programs.
• 3:01
  SPEAKER_01: You know, a public company has proxy advisory firms, institutional investors looking at and commenting on their programs.
• 3:07
  SPEAKER_01: Private companies don't usually have that.
• 3:09
  SPEAKER_01: And so there's just more flexibility for more different types of designs.
• 3:12
  SPEAKER_02: So it's interesting because when we started talking about this, I kind of had a naive view, perhaps, that this was all about valuation, because obviously you don't have quoted stock prices.
• 3:24
  SPEAKER_02: And from what you just said, that's only part of it, but I know it is part of it.
• 3:28
  SPEAKER_02: So maybe I think our first reminder is around talking about valuation.
• 3:32
  SPEAKER_01: Aaron Powell That's right.
• 3:33
  SPEAKER_01: Well, it's uh so number one is uh measuring liability awards, and there's clearly a valuation component in there.
• 3:40
  SPEAKER_01: For private companies, there is a policy choice when you have a liability award.
• 3:46
  SPEAKER_01: And and uh our listeners probably know that when you have a liability award, you have to mark it to market, which normally means marking it to fair value.
• 3:54
  SPEAKER_01: For a private company, you can elect instead to mark it to intrinsic value.
• 4:01
  SPEAKER_01: So what that means is if you picture a stock option, if I grant you a stock option today, the stock price is$10.
• 4:10
  SPEAKER_01: The exercise price will be$10.
• 4:12
  SPEAKER_01: So there is a fair value today.
• 4:15
  SPEAKER_01: People are probably familiar with the Black Scholes model.
• 4:17
  SPEAKER_01: You run a Black Shoals, maybe the fair value of that thing is$3.
• 4:20
  SPEAKER_01: The intrinsic value of that option is zero today, because the intrinsic value is just the difference between the stock price and the exercise price.
• 4:28
  SPEAKER_01: Fast forward now to the end of the year, maybe the stock price has gone up to$12.
• 4:33
  SPEAKER_01: The intrinsic value is just two bucks, just the difference between the stock price and the strike price.
• 4:39
  SPEAKER_01: So this exception basically allows a private company to avoid having to run these more complex valuations every period and instead simply do that intrinsic value subtraction model.
• 4:51
  SPEAKER_02: All right.
• 4:51
  SPEAKER_02: Although I know because that's private company only, a lot of private companies who have aspirations to become public then don't want to use those exceptions.
• 5:01
  SPEAKER_01: Yes, good point.
• 5:02
  SPEAKER_01: Uh I had this conversation many times with private companies because they say, okay, that that does seem like it would make my life easier, but uh we think we might want to go public at some point.
• 5:12
  SPEAKER_01: And so we're trying not to use any of these private company exceptions because we don't have to want to have to unwind them.
• 5:18
  SPEAKER_01: This is one of the private company exceptions that does not have to be unwound if we're going public.
• 5:24
  SPEAKER_01: So in this one, we can use the intrinsic value method all the way up until we're a public company.
• 5:31
  SPEAKER_01: And then we simply flip the switch.
• 5:33
  SPEAKER_01: Now we'll have to adjust our liability up to fair value, but we don't have to go back and do any unwinding.
• 5:39
  SPEAKER_01: So this really can make life for a private company easier while they're still private without having to worry about the unwinding when they go public.
• 5:47
  SPEAKER_02: All right.
• 5:48
  SPEAKER_02: And so then do you see that most private companies will take advantage of this then, given that you have that prospective treatment?
• 5:54
  SPEAKER_01: Very very common.
• 5:55
  SPEAKER_01: Not not all, but very common.
• 5:57
  SPEAKER_01: All right, very good.
• 5:58
  SPEAKER_02: All right, and so then what would be your second reminder?
• 6:01
  SPEAKER_01: All right, so number two is secondary transactions.
• 6:05
  SPEAKER_01: So maybe just a level set, what is a secondary transaction?
• 6:09
  SPEAKER_01: So, first of all, a primary transaction is any time company is issuing its shares either to raise capital or maybe we're gonna issue shares to buy business, something like that.
• 6:19
  SPEAKER_01: That's a primary transaction.
• 6:21
  SPEAKER_01: Secondary transaction is any transaction between shareholders in shares that are already outstanding.
• 6:29
  SPEAKER_01: Okay.
• 6:29
  SPEAKER_01: Uh secondary transactions have become more common over the last couple of years.
• 6:35
  SPEAKER_01: I think in part because companies have been delaying IPO.
• 6:40
  SPEAKER_01: And if you picture, put yourself in the shoes of an employee at a private company, they've got a bunch of stock that they've earned.
• 6:47
  SPEAKER_01: Usually they'll be able to get some cash for that because the company's gone public and they can sell it.
• 6:51
  SPEAKER_01: But now we aren't going public.
• 6:53
  SPEAKER_01: This is a way to be able to get some cash into the hands of the employee in those periods before we go public.
• 7:00
  SPEAKER_01: And they can be because we're now getting cash to an employee, that's always something that can cause potential accounting issues.
• 7:06
  SPEAKER_01: And so we want to be careful.
• 7:08
  SPEAKER_02: Right.
• 7:08
  SPEAKER_02: Well, and I think because when we talked about this before, if I remember correctly, when we have these company buybacks, then that can cause some concern that now these are liability awards.
• 7:17
  SPEAKER_01: Exactly.
• 7:18
  SPEAKER_01: Exactly.
• 7:18
  SPEAKER_01: So the first, the first bucket of secondary transactions we'll talk about is where the company is doing the purchasing, because that's not always the case.
• 7:27
  SPEAKER_01: But as you mentioned, if the company is doing the buying, then we need to be careful because anytime a company is cash settling awards with an employee, it could potentially create a liability.
• 7:38
  SPEAKER_01: So we need to think about whether when the company buys the share back from the employee, can we just treat that as a basically a treasury stock transaction, an equity buyback, or is it potentially creating a liability, liability modification of the award or of the plan?
• 7:53
  SPEAKER_01: 718 allows for a company to buy equity back from an employee without triggering liability, but it warns that if we develop a pattern of doing this, so if we're cashing out employees frequently, at some point we might kind of create a substantive cash settlement program, even though the formal terms of the plan are to be share settled.
• 8:17
  SPEAKER_01: So we need to be careful as we're developing a pattern of doing this, that we're always considering whether we're potentially tainting the plan, which could require uh now treating the entire plan as a liability arrangement and marking everything to market.
• 8:33
  SPEAKER_02: And then when you're thinking about this, is there any bright line or is it dependent?
• 8:37
  SPEAKER_01: Aaron Powell Definitely facts and circumstances.
• 8:39
  SPEAKER_01: I know some when I'm when I'm first talking to them, they kind of assume it's maybe like a three strikes and you're out type of arrangement, but I think it's much more nuanced than that.
• 8:47
  SPEAKER_01: We would want to uh consider a variety of factors, including, well, first of all, how often has it been done?
• 8:53
  SPEAKER_01: Uh how how much time has gone by between each of the repurchases?
• 8:58
  SPEAKER_01: Are we repurchasing from everybody or are we just repurchasing kind of on a one-off basis from individual employees?
• 9:03
  SPEAKER_01: What was the reason that we were repurchasing from the employees?
• 9:06
  SPEAKER_01: There's sort of some kind of story behind it.
• 9:07
  SPEAKER_01: So certainly not a bright line, certainly not street three strikes, and we've got uh facts and circumstances to consider.
• 9:13
  SPEAKER_02: And then I know in the past we've talked a bit about the six-month rule.
• 9:16
  SPEAKER_02: So how does that sort of fit in here?
• 9:19
  SPEAKER_01: Right.
• 9:19
  SPEAKER_01: So without getting too far into the weeds on the six-month rule, because that's really kind of getting into liability accounting.
• 9:27
  SPEAKER_01: It is important to understand that if a company's buying shares that have been held for at least six months, then we don't even have to consider that a strike.
• 9:35
  SPEAKER_01: Okay.
• 9:36
  SPEAKER_01: Companies always able to buy shares from employees that have been held for at least six months, and that is always just treated as an equity transaction, as long as it's being bought at fair value.
• 9:46
  SPEAKER_01: That's an important element of it.
• 9:47
  SPEAKER_01: But if we're buying at fair value and the shares have been held at least six months, that's just equity no matter what.
• 9:53
  SPEAKER_01: If we're buying shares that haven't been held six months, we call those immature shares, that's where we can get into these potential concerns and where we need to be much more careful.
• 10:02
  SPEAKER_02: And then do you see a lot of cases where it is under the six-month window?
• 10:06
  SPEAKER_02: Because six months is a relatively short period of time.
• 10:10
  SPEAKER_01: Yeah, uh, it can happen for a variety of reasons.
• 10:12
  SPEAKER_01: In part, um, you know, a lot of private companies still use options more frequently than shares.
• 10:18
  SPEAKER_01: And so the six-month clock doesn't start when you vest in an option.
• 10:22
  SPEAKER_01: The the clock starts when you become an actual shareholder.
• 10:25
  SPEAKER_01: So with an option, it doesn't start until you've exercised the option.
• 10:29
  SPEAKER_01: And a lot of times with these buybacks, the option is still being held by the employee.
• 10:34
  SPEAKER_01: They haven't exercised it.
• 10:35
  SPEAKER_01: And so the shares are not even mature for one day when the buyback happens.
• 10:39
  SPEAKER_01: That's one example of where we see this.
• 10:42
  SPEAKER_02: That's very helpful.
• 10:43
  SPEAKER_02: And then immediately what popped into mind when you were talking about these purchases is that you know, you have a company, but then often you have the major investors in the company.
• 10:53
  SPEAKER_02: So what if it's the investor that's buying back the stock instead of the company?
• 10:57
  SPEAKER_02: And how do you really differentiate in some cases?
• 11:00
  SPEAKER_02: Yeah.
• 11:00
  SPEAKER_01: So yeah, we're seeing more of that as well.
• 11:04
  SPEAKER_01: So yeah, this is a this is a situation where employees holding shares, we want to get some liquidity, some cash to the employee instead of the company buying, uh, an investor in the company will do the buying.
• 11:17
  SPEAKER_01: And there are a couple of issues that we always want to think about when it's the investor doing the buying.
• 11:24
  SPEAKER_01: The first, so it's valuation considerations.
• 11:28
  SPEAKER_01: How do we think about the impact of this transaction on the value of the stock itself?
• 11:33
  SPEAKER_01: And then whether we're creating any compensation expense as a result of the transaction.
• 11:39
  SPEAKER_01: So let's start with the valuation.
• 11:40
  SPEAKER_01: So private companies typically will have a valuation of their common stock performed periodically.
• 11:48
  SPEAKER_01: Those are sometimes referred to as 409A valuations.
• 11:52
  SPEAKER_02: Is that tax codes?
• 11:54
  SPEAKER_01: Yeah, okay.
• 11:54
  SPEAKER_01: 409A is tax code and uh requires that it relates to stock options and stock options having to be granted at the money, and so 409A is the valuation to prove that the options granted at the money.
• 12:05
  SPEAKER_02: Got it.
• 12:06
  SPEAKER_02: It just was a very specific term, otherwise, yes.
• 12:09
  SPEAKER_01: But very commonly used 409A valuation.
• 12:11
  SPEAKER_01: You'll probably hear this.
• 12:12
  SPEAKER_01: Um, in the secondary transaction, so we've got the investor buying from the employee.
• 12:17
  SPEAKER_01: It is very common that the price that's being paid is something in excess of whatever that last 409A valuation was.
• 12:26
  SPEAKER_01: That can happen for a variety of reasons.
• 12:29
  SPEAKER_01: So, for example, maybe the last 409A was a couple of months ago.
• 12:33
  SPEAKER_01: It came in at$3.
• 12:35
  SPEAKER_01: Now we've got an investor buying from an employee at$10.
• 12:39
  SPEAKER_01: So we need to think about, we've got a real market transaction happening.
• 12:43
  SPEAKER_01: How do we think about the impact of that market transaction on the value of the stock today?
• 12:49
  SPEAKER_01: We don't necessarily have to assume that that market transaction means the fair value is$10, but we clearly have to consider that market transaction when we're thinking about kind of the overall value of the share.
• 13:05
  SPEAKER_01: Uh, very judgmental valuation experts should be involved.
• 13:09
  SPEAKER_01: Some weight probably needs to be placed on it, but maybe not 100%.
• 13:12
  SPEAKER_01: And so we're going to kind of triangulate between that market transaction and then the other valuation techniques that are used.
• 13:18
  SPEAKER_01: And maybe we'll say the value of the stock today is$6 as a result of this transaction that's happening.
• 13:25
  SPEAKER_02: So, as a non-valuation person, it seems like a market transaction.
• 13:31
  SPEAKER_02: So you bought stock from me, would be the best evidence of the price.
• 13:34
  SPEAKER_02: So just very high level, what are some of the reasons that wouldn't be really a demonstration of the fair value?
• 13:41
  SPEAKER_01: Well, one would be that it's a single transaction, and the fewer transactions that are happening, the less uh evidence of value that we might play.
• 13:50
  SPEAKER_01: So that's like one factor that might uh that might play into it.
• 13:53
  SPEAKER_01: Also, depending on the size of the investor, if it's a very small investor, we might say that they were willing to pay more for various reasons just because they wanted to get in, even though they kind of acknowledge that they're paying more than fair value.
• 14:09
  SPEAKER_01: And so simply relying solely on that one market transaction probably isn't the best evidence of fair value.
• 14:14
  SPEAKER_02: All right.
• 14:15
  SPEAKER_02: That's helpful.
• 14:16
  SPEAKER_02: So I think then you're starting to run through the expense.
• 14:18
  SPEAKER_01: Right.
• 14:19
  SPEAKER_01: So so now we've talked about the the valuation considerations.
• 14:23
  SPEAKER_01: And again, that's very that's highly judgmental.
• 14:25
  SPEAKER_01: We need to make sure we're getting comfortable that we've come up with a good value today.
• 14:29
  SPEAKER_01: But let's say now we believe the fair value of that share is six dollars today.
• 14:34
  SPEAKER_01: The investor just paid our employee$10.
• 14:37
  SPEAKER_01: So we've got a$4 delta still that we need to think about.
• 14:41
  SPEAKER_01: $718 has a concept, it's referred to the economic interest holder, which is basically any anybody who has an economic interest in the business.
• 14:52
  SPEAKER_01: An investor clearly is an economic interest holder.
• 14:55
  SPEAKER_01: And the guidance says if you have not the company compensating an employee, but an economic interest holder giving some compensation to an employee, unless it's clearly for some other purpose, we have to assume that they're doing that on behalf of the company to compensate the employee, and therefore the company has to recognize expense related to it.
• 15:16
  SPEAKER_01: Even though, again, it's not the company who's paying the employee.
• 15:19
  SPEAKER_01: So that's a general economic interest holder concept.
• 15:22
  SPEAKER_01: In this arrangement, the secondary transaction that we're talking about, again, we've got an investor paying an employee$10.
• 15:30
  SPEAKER_01: We've already said that the value of the share that they're buying is only$6.
• 15:35
  SPEAKER_01: And so there's a presumption then that that delta of$4 represents compensation, and the company would have to recognize a compensation expense charge for that$4.
• 15:46
  SPEAKER_01: It's not black and white, and there's a variety of factors to consider when making this assessment.
• 15:51
  SPEAKER_01: But the general principle, as I described, is if you've got an economic interest holder who's making a payment to an employee, the presumption is we need to treat that as compensation.
• 16:00
  SPEAKER_02: And then I just was trying to process through this.
• 16:04
  SPEAKER_02: If the company itself had done the same transaction, then would you have the same accounting outcome?
• 16:10
  SPEAKER_01: Yeah, yeah.
• 16:11
  SPEAKER_01: Good point.
• 16:12
  SPEAKER_01: If the company paid$10 to the employee for a share that was only worth$6, then likewise we'd say there's incremental value there.
• 16:20
  SPEAKER_01: Basically, we've we've given them an extra$4 above the value of the share that we bought from them.
• 16:25
  SPEAKER_02: So basically, in this case, then whether it's investor or the company itself, it's basically the investors considered to be part of the company effectively.
• 16:35
  SPEAKER_02: Correct.
• 16:35
  SPEAKER_02: Okay.
• 16:36
  SPEAKER_02: That's right.
• 16:36
  SPEAKER_02: All right, very helpful.
• 16:38
  SPEAKER_02: So then what would be the next point that you would focus on?
• 16:42
  SPEAKER_01: All right.
• 16:42
  SPEAKER_01: So number three, let's move into another hot area in private companies, which is profits interests.
• 16:49
  SPEAKER_01: So a profits interest for our listeners who don't see these things every day.
• 16:55
  SPEAKER_01: This is a, first of all, they can only be issued out of a partnership or an LLC.
• 17:01
  SPEAKER_01: It's a legal form ownership interest in the entity.
• 17:06
  SPEAKER_01: The economics of a profits interest is that it only entitles the holder to future appreciation of value.
• 17:15
  SPEAKER_01: So on the day I receive my profits interest, if we were to sell the company, I wouldn't be entitled to any of the cash.
• 17:22
  SPEAKER_01: I only will be entitled to some cash of the value of the business increases in the future.
• 17:27
  SPEAKER_01: These things are they get special treatment for tax purposes.
• 17:32
  SPEAKER_01: For tax purposes, they are viewed to have zero value on day one, because if we were to liquidate, I wouldn't get anything.
• 17:39
  SPEAKER_01: And so for tax, there's no ordinary income ever associated with one of these arrangements.
• 17:45
  SPEAKER_01: All of that future appreciation is capital gains.
• 17:47
  SPEAKER_01: So very tax preferred for the employee.
• 17:51
  SPEAKER_01: And so we see these pretty commonly when we're dealing with any entity that has a partnership or an LLC in the structure.
• 17:57
  SPEAKER_01: But there's lots of designs and bells and whistles that we see in these arrangements.
• 18:03
  SPEAKER_01: And there was a there was an SEC staff speech almost 20 years ago now that acknowledged that these profits interests can take lots of different forms.
• 18:12
  SPEAKER_01: And so we need to use judgment in thinking about whether, even though it's a legal form equity interest, is it acting like real equity or is it acting more like some kind of profit sharing bonus type arrangement?
• 18:28
  SPEAKER_01: And if it's acting like equity, then we'd be in stock compensation literature, 718.
• 18:32
  SPEAKER_01: If not, we would be somewhere else, probably ASC 710, which is just deferred compensation.
• 18:38
  SPEAKER_02: So then to that point, you referenced this speech, but I know that the FASBE actually put out guidance earlier this year.
• 18:44
  SPEAKER_02: So how does that fit into this conversation?
• 18:47
  SPEAKER_01: Right.
• 18:47
  SPEAKER_01: So uh up until this year, we only had the speech to look to, and the FASBE has gotten some requests to provide a little bit more clarity around how to think about uh this.
• 18:58
  SPEAKER_01: And so the the FASB put an ASU out, which deals only with this scoping question.
• 19:04
  SPEAKER_01: Is it in 718 or not?
• 19:07
  SPEAKER_01: And it's an example that has four cases, four different fact patterns of profits interests, and kind of analyzes each one and says, yes, this is in 718 or no, this is out.
• 19:18
  SPEAKER_01: But the FASB acknowledges these are just four examples, but there's lots of different flavors.
• 19:24
  SPEAKER_01: And so judgment is still going to be necessary when we're analyzing one of these arrangements.
• 19:30
  SPEAKER_01: One of the primary factors that we look at when we're assessing a profits interest is what happens when the employee leaves the company, if they've vested already in the profits interest.
• 19:44
  SPEAKER_01: So if when they leave the company, either they can just continue to hold the profits interest in perpetuity, or if the company has the ability to repurchase it, but uh the repurchase price is fair value, either of those things would be equity-like characteristics, and that would point us toward 718s.com.
• 20:05
  SPEAKER_01: Conversely, if the employee is leaving and either the profits interest just automatically forfeits on termination, even if you've already satisfied vesting requirements, it just automatically goes away when you leave.
• 20:18
  SPEAKER_01: Uh or sometimes we'll see a company repurchase provision that maybe is at zero dollars.
• 20:24
  SPEAKER_01: I can buy it back from you for nothing, uh, or at some amount that is clearly below fair value, those would be indicators that this is not acting like equity.
• 20:32
  SPEAKER_01: I can't hold it after I leave.
• 20:35
  SPEAKER_01: Uh I get bought out at something that's not fair value.
• 20:37
  SPEAKER_01: So really it's it's acting like as long as I'm working, if there are any distributions, I'm getting some.
• 20:45
  SPEAKER_01: Yeah.
• 20:45
  SPEAKER_01: But as soon as I leave, I'm not getting any more.
• 20:47
  SPEAKER_01: That's more like just a profit sharing bonus kind of plan.
• 20:50
  SPEAKER_01: So that's how we think about it.
• 20:52
  SPEAKER_02: So from a practical point of view, then, did the issuance of this ASU actually change practice or was it more codifying current practice?
• 20:59
  SPEAKER_01: Right.
• 20:59
  SPEAKER_01: So I would say it's codifying current practice.
• 21:02
  SPEAKER_01: The request originally came in from, I think, some some smaller private companies who just didn't they they might not be audited by big four firms.
• 21:11
  SPEAKER_01: I think the big four accounting firms all have guidance that's pretty consistent and has been applied for a long time, but not everybody has a big four auditor, et cetera.
• 21:19
  SPEAKER_01: And uh, and so uh the the request came in to just provide some guidance to help kind of level the playing field and get everybody growing in the same direction.
• 21:26
  SPEAKER_01: So it it really shouldn't change the way that we've been analyzing these things over the years.
• 21:31
  SPEAKER_02: All right, that's helpful.
• 21:32
  SPEAKER_02: So adoption of this ASU is not wouldn't be expected to cause a big change.
• 21:37
  SPEAKER_01: Correct.
• 21:37
  SPEAKER_01: And maybe one red flag that I'll point out related to profits interest.
• 21:41
  SPEAKER_01: So let's say we are in 718.
• 21:45
  SPEAKER_01: We do think that this thing is stock compensation, and we believe it's equity classified once we get into 718.
• 21:53
  SPEAKER_01: So we need to determine the fair value on day one.
• 21:57
  SPEAKER_01: When some uh look at these profits.
• 22:00
  SPEAKER_01: Its interests, because for tax purposes they're viewed to have zero value on day one.
• 22:05
  SPEAKER_01: That's explicit in the tax rule.
• 22:08
  SPEAKER_01: They assume that that means it's got zero value for accounting purposes on day one as well.
• 22:14
  SPEAKER_01: That's not the case.
• 22:15
  SPEAKER_01: There is a fair value for this interest because it's got future upside potential, even though it doesn't have any like day one liquidation value.
• 22:25
  SPEAKER_01: So we still have to come up with a fair value because the thing operates economically very similar to a stock option, right?
• 22:31
  SPEAKER_01: You get future appreciation value.
• 22:34
  SPEAKER_01: These are valued similar to a stock option.
• 22:36
  SPEAKER_01: So valuation experts will usually use a black shoals type model to value these profits and interests.
• 22:42
  SPEAKER_02: All right.
• 22:42
  SPEAKER_02: Very helpful.
• 22:43
  SPEAKER_02: So then one of the things you mentioned up front is the fact that some of the complexities with private company awards are some of the different unique structures and otherwise that they can have.
• 22:53
  SPEAKER_02: And I know that your fourth reminder is around equity restructuring.
• 22:57
  SPEAKER_02: So what are some of the things you need to think about there?
• 23:00
  SPEAKER_01: That's right.
• 23:01
  SPEAKER_01: So let's set the playing field on equity restructuring, because probably another term that not everyone is familiar with.
• 23:07
  SPEAKER_01: So I'll use the fancy definition, then I'll explain the fancy definition.
• 23:10
  SPEAKER_01: So it's a an equity restructuring is a non-reciprocal transaction between the company and shareholders that causes the stock price to change.
• 23:20
  SPEAKER_01: Okay.
• 23:21
  SPEAKER_01: It's a lot of fancy work.
• 23:22
  SPEAKER_02: Yes.
• 23:23
  SPEAKER_01: So non-reciprocal transaction between the company and shareholders.
• 23:28
  SPEAKER_01: So this means we've got something going out the door to our shareholders, and we're not getting anything in return.
• 23:34
  SPEAKER_01: So it's non-reciprocal.
• 23:36
  SPEAKER_01: And as a result of whatever just went out the door, the stock price is going to change as a result.
• 23:43
  SPEAKER_01: So the easiest example that I like to think about for an equity restructuring is a stock split.
• 23:48
  SPEAKER_01: Stock split is actually the company distributing shares to its current owners.
• 23:55
  SPEAKER_01: Let's say there's 100 shares outstanding right now, the company distributes an additional 100 shares.
• 24:01
  SPEAKER_01: So that's a non-reciprocal transaction.
• 24:03
  SPEAKER_01: We've got 100 shares going out the door.
• 24:05
  SPEAKER_01: We're not getting anything in return.
• 24:07
  SPEAKER_01: And of course, that's going to have an uh immediate impact on the stock price.
• 24:11
  SPEAKER_01: Yes.
• 24:11
  SPEAKER_01: There were 100 shares outstanding yesterday.
• 24:14
  SPEAKER_01: Today there are 200 shares outstanding.
• 24:17
  SPEAKER_01: Of course, the stock price is going to drop by half.
• 24:19
  SPEAKER_02: Right.
• 24:20
  SPEAKER_01: So that's an easy example of equity restructuring to think about.
• 24:23
  SPEAKER_01: That's not the common example in private companies, though.
• 24:26
  SPEAKER_01: So with a private company, what we often see is what's referred to as a leveraged recap with a special dividend.
• 24:35
  SPEAKER_01: Okay.
• 24:36
  SPEAKER_01: More fancy words.
• 24:37
  SPEAKER_02: Yes, I can see why you started with the stock split.
• 24:39
  SPEAKER_01: Yeah, keep it simple to start, and then we can dive in.
• 24:41
  SPEAKER_01: So this is the leveraged recap with the special distribution.
• 24:45
  SPEAKER_01: So leveraged recap means the company is just taking on some debt from a bank, right?
• 24:50
  SPEAKER_01: So maybe they borrow a hundred million dollars, and then they distribute that as a special dividend to the owners.
• 24:57
  SPEAKER_01: So that is an equity restructuring.
• 24:59
  SPEAKER_01: It's non-reciprocal transaction.
• 25:01
  SPEAKER_01: We got$100 million going out, nothing, we're not getting anything in return.
• 25:05
  SPEAKER_01: And that is going to have an impact on the stock price because we just had$100 million leave the company.
• 25:12
  SPEAKER_01: So the stock price is going to come down as a result.
• 25:15
  SPEAKER_02: All right.
• 25:15
  SPEAKER_02: So then how does this actually impact the stock comp that's recognized?
• 25:20
  SPEAKER_01: All right.
• 25:20
  SPEAKER_01: So we've just had this$100 million distribution paid.
• 25:25
  SPEAKER_01: And let's say that was that equated to$3 per share.
• 25:29
  SPEAKER_01: I'm an employee.
• 25:30
  SPEAKER_01: I'm holding a stock option.
• 25:32
  SPEAKER_01: Maybe my stock option had a$10 exercise price, and yesterday the stock price was$10.
• 25:40
  SPEAKER_01: Well, today that stock price is going to come down by$3 because we just had this equity restructuring.
• 25:46
  SPEAKER_01: So that it that harms me.
• 25:50
  SPEAKER_01: The value of my option is going to come down as a result of that because the exercise price is still$10, but now the stock price is$7.
• 25:59
  SPEAKER_01: Most plans these days will have a provision that requires the company to make the option holder whole so that they don't get harmed as a result of this.
• 26:10
  SPEAKER_01: That's referred to as an anti-dilution provision.
• 26:14
  SPEAKER_01: So whether the anti-dilution provision requires that make hole or not is important.
• 26:20
  SPEAKER_01: If it doesn't require the make hole, then there are additional accounting issues, which we won't even go into here because it's not that common anymore.
• 26:28
  SPEAKER_01: It used to be an issue back in the day, but everybody, most people have their arms around it now.
• 26:32
  SPEAKER_01: But assuming that there is a required make hole, then the company can make the employee whole in a variety of ways.
• 26:40
  SPEAKER_01: The anti-dilution protection doesn't usually say how to make them whole.
• 26:44
  SPEAKER_01: It just says you shall make the holder whole.
• 26:47
  SPEAKER_01: So we see a variety of ways to make whole.
• 26:49
  SPEAKER_01: In our example, we could adjust the exercise price from maybe 10 down to seven to keep the person whole.
• 26:57
  SPEAKER_01: Maybe we can issue them additional awards to make up for the value that was lost as a result.
• 27:03
  SPEAKER_01: Or sometimes in these situations where the equity restructuring was a cash distribution that was being made, there might be a cash make hole payment that is made to the option holders.
• 27:14
  SPEAKER_02: All right.
• 27:15
  SPEAKER_02: And then I know you like red flags.
• 27:17
  SPEAKER_02: So what are the red flags in this type of transaction?
• 27:22
  SPEAKER_01: Right.
• 27:22
  SPEAKER_01: So I I think the the red flags come when the make hole is with a cash payment.
• 27:30
  SPEAKER_01: Um, and there's a couple things to watch out for.
• 27:32
  SPEAKER_01: Maybe the first is the anti-dilution protection required us to make the person whole, but we still need to treat whatever the make hole is as a modification just to make sure we're not giving them any incremental value.
• 27:46
  SPEAKER_01: We talked on our previous podcast about modifications and incremental value, so we need to be careful about that.
• 27:52
  SPEAKER_01: With a cash make hole, there usually would be a little bit of incremental value because the value of the option uh is probably not going to come down by a full$3 in our example, just a result of how the Black Shoal model works.
• 28:08
  SPEAKER_01: Maybe it'll come down by$2.50.
• 28:10
  SPEAKER_01: But we've given$3 of makehole cash.
• 28:13
  SPEAKER_01: And so the value of what I'm holding after this modification is actually a little bit greater than what I was holding before.
• 28:19
  SPEAKER_01: So that incremental value needs to be recognized.
• 28:22
  SPEAKER_01: But one of the common traps I see some falling into is there's there's a presumption that since we're paying$3 of cash, we have$3 of expense that we need to recognize.
• 28:33
  SPEAKER_01: And it just kind of feels natural because we're making a payment to an employee.
• 28:36
  SPEAKER_01: It's like a bonus we should be.
• 28:38
  SPEAKER_01: That is not how it works because we had this required anti-dilution protection.
• 28:43
  SPEAKER_01: So there will be some incremental to recognize, but it wouldn't be the full amount of the cash payment.
• 28:50
  SPEAKER_02: So if you made a payment of$3, but you're only adjusting the stock comp by, say$250 in your example, then where does the remaining debit go?
• 29:00
  SPEAKER_01: Good question.
• 29:00
  SPEAKER_01: So that that would be treated as equity.
• 29:02
  SPEAKER_02: Okay.
• 29:03
  SPEAKER_01: So it'd be basically credit cash, debit equity for the$2.50, and then debit expense for the remaining 50 cents.
• 29:11
  SPEAKER_01: It's we're it's basically like we had an arrangement that originally we thought would be fully equity settled, but now we're partially settling it with some cash.
• 29:20
  SPEAKER_01: And so we're we're reversing some of that equity.
• 29:22
  SPEAKER_01: That's the debit to equity and credit.
• 29:25
  SPEAKER_02: Oh, and then you're giving.
• 29:26
  SPEAKER_02: I see.
• 29:27
  SPEAKER_02: I see.
• 29:27
  SPEAKER_02: Okay, that's very helpful.
• 29:29
  SPEAKER_02: Any other red flags?
• 29:30
  SPEAKER_01: Yeah.
• 29:31
  SPEAKER_01: So sometimes the cash that is paid is fully vested, even though the underlying option still has some service required.
• 29:39
  SPEAKER_01: Maybe there's another another year of service required.
• 29:42
  SPEAKER_01: Sometimes it's fully vested, sometimes not.
• 29:44
  SPEAKER_01: Let's start with fully vested.
• 29:46
  SPEAKER_01: So if the cash payment is fully vested, then what we've effectively done is accelerate the vesting on some of this arrangement.
• 29:55
  SPEAKER_01: Yesterday I had to keep working for another year to get any value out of this thing.
• 30:00
  SPEAKER_01: Today, I only have to keep working to get a portion of the value, the portion related to the option, and I've got fully vested cash today.
• 30:07
  SPEAKER_01: So that's a partial acceleration of vesting.
• 30:10
  SPEAKER_01: That's a modification, and we would need to think about what are the implications of that modification to accelerate vesting.
• 30:16
  SPEAKER_01: If the cash is not vested, so I have to keep working for the next year to earn the option and to earn the cash, the$3 of cash, then we've created an equity to liability modification because yesterday I had an arrangement that was fully share settled, so fully equity classified.
• 30:38
  SPEAKER_01: Today I have an arrangement where some of it will be equity settled, that's the option, and some of it will be cash settled, that's the$3.
• 30:46
  SPEAKER_01: So a portion of my arrangement I now need to treat as an equity to liability modification, which we talked about in our previous podcast, which basically means we have some amount of mark-to-market charge that we're going to need to take to get our liability recognized.
• 31:01
  SPEAKER_02: All right.
• 31:02
  SPEAKER_02: So big picture, I think a key point here is that any of these modifications, even though it's private company, even though they may seem more complex and some of the sort of plain vanilla modifications we talked about in the last episode, you still need to be considering those models when you're doing the accounting.
• 31:18
  SPEAKER_01: Definitely.
• 31:19
  SPEAKER_01: Definitely with these equity restructurings, we need to be careful about any potential modifications that are happening.
• 31:25
  SPEAKER_02: All right, very helpful.
• 31:26
  SPEAKER_02: All right, so I know you have one more reminder, and I'm sure it's another complicated issue.
• 31:30
  SPEAKER_02: So what's this one?
• 31:31
  SPEAKER_01: Well, that's why we did this whole thing on private companies.
• 31:34
  SPEAKER_01: There are there are these tricky issues that private companies face.
• 31:37
  SPEAKER_01: Yeah.
• 31:38
  SPEAKER_01: All right.
• 31:38
  SPEAKER_01: So number five, last item is recourse and non-recourse loans.
• 31:43
  SPEAKER_01: So we will see sometimes private companies will make a loan to employee to purchase stock of the company.
• 31:54
  SPEAKER_01: When they make that loan, the first step is to determine whether the loan is recourse or non-recourse.
• 32:03
  SPEAKER_01: So recourse means we intend to collect on this loan, and if the employee fails to pay, we're going to go after them and we'll go after any assets of the employee, house, car, boat, whatever.
• 32:16
  SPEAKER_01: So that is as opposed to a non-recourse loan where if the employee fails to pay, we don't have any recourse against the employee's assets.
• 32:29
  SPEAKER_01: All we can go after is the share that they purchased with that loan.
• 32:34
  SPEAKER_01: So if the employee doesn't pay, they just give the share back, and that's all.
• 32:37
  SPEAKER_01: So that's the difference, and then that can result in some accounting implications.
• 32:42
  SPEAKER_02: Yeah, so I would guess that these differences then in the economics will also result in differences in accounting.
• 32:48
  SPEAKER_01: Right.
• 32:49
  SPEAKER_01: So maybe to start with recourse, which is a bit more straightforward, a recourse loan we view as a kind of a real loan to the employee.
• 32:58
  SPEAKER_01: And so we're going to recognize the loan.
• 33:01
  SPEAKER_01: We would, as a put instead of setting it up as an asset, we would recognize it uh within equity because it was used to purchase equity, but we're still treating it as a real loan.
• 33:12
  SPEAKER_01: And one red flag to watch out for with the full recourse loans is to make sure that the interest rate that the employee has to pay on the loan is a market rate.
• 33:22
  SPEAKER_01: Sometimes we will see these recourse loans being uh given to employees at below market rates.
• 33:28
  SPEAKER_01: There's a compensatory element there because the employee is basically getting some benefit simply because they get to pay a below market rate for the loan.
• 33:35
  SPEAKER_01: But otherwise, we just treat it as a real purchase of the stock in exchange for a real loan.
• 33:41
  SPEAKER_01: It's the non-recourse loans where things get trickier, and this is where it's important to think about the, as you mentioned, the economics when we're thinking about what the accounting should be.
• 33:51
  SPEAKER_01: So I borrow from the company$100 to buy a share of stock that's worth$100.
• 33:58
  SPEAKER_01: Um, if the stock price goes up maybe to$120, I'll pay off my loan of$100 and I've got a share that's worth$120.
• 34:07
  SPEAKER_01: If the value of the stock goes down to$80, then I'm probably not going to want to pay off my$100 loan to get a share of stock that's worth$80.
• 34:17
  SPEAKER_01: So I'll just say, forget it.
• 34:18
  SPEAKER_01: I'm not paying off this loan, and you can have your share of stock back.
• 34:22
  SPEAKER_01: That arrangement, even though in form it's structured as a loan to buy shares, it is acting like a stock option, right?
• 34:30
  SPEAKER_01: There's a hundred dollar exercise price.
• 34:32
  SPEAKER_01: If the value of the stock goes up, I'm going to pay that exercise price and get my share.
• 34:37
  SPEAKER_01: If the value of the stock goes down, I'm not going to exercise.
• 34:40
  SPEAKER_01: I'm not going to pay anything, and I just won't get my share.
• 34:44
  SPEAKER_01: And the guidance explicitly acknowledges that these non-recourse loans should be accounted for as stock options.
• 34:51
  SPEAKER_01: And that's exactly what we do.
• 34:53
  SPEAKER_01: So we just treat it like a stock option, we value it, black shoals like a stock option.
• 34:57
  SPEAKER_01: Uh, if there's a service requirement, we would spread it over the service period.
• 35:01
  SPEAKER_01: Otherwise, we would just take all of that as an expense charge on the day of the arrangement.
• 35:05
  SPEAKER_02: And then Ken, how common are all these different fact patterns?
• 35:09
  SPEAKER_02: And again, I know we talked about a lot of different types of fact patterns, but are they relatively common or you would say that these are more rare cases?
• 35:18
  SPEAKER_01: I would say uh after going through these top five, uh, most private companies probably have at least one of these.
• 35:25
  SPEAKER_01: Okay.
• 35:26
  SPEAKER_01: It depends on you know, some portfolio companies of private equity firms, they might be more likely to have the equity restructuring thing that we talked about.
• 35:35
  SPEAKER_01: Other more steady-state private companies, it might be more common to have some of these non-recourse loans that we talked about.
• 35:41
  SPEAKER_01: But uh everybody's probably impacted somewhere on this list.
• 35:45
  SPEAKER_02: All right, so pay attention.
• 35:46
  SPEAKER_02: So then, with that said, then, what advice would you give to companies that are dealing with these different types of transactions?
• 35:53
  SPEAKER_01: Uh, one piece of advice I always give, because these things get complicated, is to make sure that we have good coordination and communication within the company amongst all of the different groups that play some role.
• 36:08
  SPEAKER_01: So HR is involved in some way, finance, legal, stock plan administration, tax.
• 36:14
  SPEAKER_01: There's a lot of different players.
• 36:16
  SPEAKER_01: And too often, unfortunately, I find that there's not always great communication between them, and then surprises pop up after the fact.
• 36:24
  SPEAKER_01: So that that would be one good coordination.
• 36:26
  SPEAKER_01: Uh, and then maybe a self-serving plug for us accounting people to make sure that we've got the right accounting folks in the mix early on, because once again, too often, unfortunately, we see problems on the back end because something was designed and structured, and then the accountants are brought in later on, and then uh we get some unintended consequences.
• 36:47
  SPEAKER_02: All right, definitely a good plug there.
• 36:49
  SPEAKER_02: And then if someone wanted to go read more about some of these issues, what's the best place to look?
• 36:53
  SPEAKER_01: So, in our stock compensation guide, chapter six is uh devoted solely to private company issues.
• 37:01
  SPEAKER_02: All right.
• 37:01
  SPEAKER_02: Well, Ken, it's always such a pleasure to talk to you.
• 37:04
  SPEAKER_02: Thanks so much for joining me.
• 37:05
  SPEAKER_01: Thank you, Heather.
• 37:07
  SPEAKER_02: That's our show for today.
• 37:09
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• 37:19
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• 37:29
  SPEAKER_02: From Thought Leadership at PWC, I'm Heather Horn.
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