Emerging companies — Common-stock repurchase transactions | Deloitte US | Financial Reporting Alert | 2018 | 18-7 has been added to your bookmarks.
Emerging growth companies — Common-stock repurchase transactions
Financial Reporting Alert 18-7
This Financial Reporting Alert discusses accounting, valuation, tax, and interpolation framework considerations for nonpublic entities related to various transactions involving the repurchase of a nonpublic entity’s common stock. Such stock transactions can be between the nonpublic entity and its employees, a preexisting investor and the nonpublic entity’s employees, or a new investor and the nonpublic entity’s employees.
Various stock transactions with employees of a nonpublic emerging growth company (the “nonpublic entity”) involve significant judgment and complexities that may have a material impact on the nonpublic entity’s financial statements. In addition, such transactions often have certain tax implications for both the nonpublic entity and its employees. These stock transactions can be between the nonpublic entity and its employees, a preexisting investor and the nonpublic entity’s employees, or a new investor and the nonpublic entity’s employees.
This second installment in our special Financial Reporting Alert series for start-up companies discusses accounting, valuation, tax, and interpolation framework considerations for nonpublic entities related to various transactions involving the repurchase of a nonpublic entity’s common stock.
Transactions Directly Between a Nonpublic Entity and Its Employees
When a nonpublic entity repurchases common shares from its employees at an amount greater than the estimated fair value of the shares at the time of the transaction, the excess of the purchase price over the fair value of the common shares generally represents employee compensation. The excess amount attributable to compensation would be reflected in the nonpublic entity’s financial statements as compensation cost.
ASC 718 discusses the accounting for repurchases at a price in excess of fair value. Specifically, ASC 718-20-35-7 states the following:
The amount of cash or other assets transferred (or liabilities incurred) to repurchase an equity award shall be charged to equity, to the extent that the amount paid does not exceed the fair value of the equity instruments repurchased at the repurchase date. Any excess of the repurchase price over the fair value of the instruments repurchased shall be recognized as additional compensation cost. An entity that repurchases an award for which the requisite service has not been rendered has, in effect, modified the requisite service period to the period for which service already has been rendered, and thus the amount of compensation cost measured at the grant date but not yet recognized shall be recognized at the repurchase date. [Emphasis added]
For example, a nonpublic entity may repurchase shares from its existing employees in connection with a convertible preferred stock financing. As part of the financing, the entity may set aside a specified amount of the money to repurchase common stock from its existing employees and thereby provide liquidity to its employees. It is not unusual for an entity to repurchase common shares by using the price established for the preferred stock in the most recent round of financing. Accordingly, a nonpublic entity would need to evaluate whether the price of the preferred stock is equal to the value of the common stock. Typically, the value of preferred shares will exceed the value of common shares (assuming one-to-one conversion) because of preferential rights normally associated with preferred shares. As a result, the excess amount (i.e., the difference between the purchase price and the fair value of the underlying shares) would be reflected in the nonpublic entity’s financial statements as compensation cost in accordance with ASC 718-20-35-7.
Transactions Directly Between a Preexisting Investor and the Nonpublic Entity’s Employees as Part of a Financing Transaction
On occasion, investors (e.g., private equity or venture capital investors) intending to increase their stake in an emerging nonpublic entity may undertake transactions with other shareholders in connection with a recent financing round. These transactions may include investors’ purchase of common shares directly from the founders of the nonpublic entity or other individuals who are also considered employees of the nonpublic entity. Because the transactions are between employees of the nonpublic entity and existing shareholders and are related to the transfer of outstanding shares, the nonpublic entity may not be directly involved in them (although it may become indirectly involved by facilitating the exchange or not exercising a right of first refusal).
Sometimes, if there is sufficient evidence that a transaction is an arm’s-length fair value transaction, it may be necessary to treat the transaction as a data point in the estimation of the fair-value-based measurement of share-based payment awards. Other times, particularly when a transaction involves founders or a few select key employees, it may be difficult to demonstrate that the transaction is not compensatory. If the price paid for the shares exceeds their fair value at the time of the transaction, it is likely that the nonpublic entity will be required to recognize compensation cost for the excess regardless of whether the entity is directly involved in the transaction. It is important for a nonpublic entity to recognize that transactions such as these may be subject to the guidance in ASC 718 because the investors are considered to be holders of an economic interest in the entity.
ASC 718-10-15-4 states the following:
Share-based payments awarded to an employee of the reporting entity by a related party or other holder of an economic interest in the entity as compensation for services provided to the entity are share-based payment transactions to be accounted for under this Topic unless the transfer is clearly for a purpose other than compensation for services to the reporting entity. The substance of such a transaction is that the economic interest holder makes a capital contribution to the reporting entity, and that entity makes a share-based payment to its employee in exchange for services rendered. An example of a situation in which such a transfer is not compensation is a transfer to settle an obligation of the economic interest holder to the employee that is unrelated to employment by the entity. [Emphasis added]
Although the presumption in such transactions is that any consideration in excess of the fair value of the shares is compensation paid to employees, nonpublic entities should consider whether the amount paid is related to an existing relationship or to an obligation that is unrelated to the employees’ services to the entity in assessing whether the payment is “clearly for a purpose other than compensation for services to the reporting entity.” Even though it is difficult to demonstrate that a non-fair-value transaction with employees is clearly for other purposes, AIN-APB 25 (superseded by FASB Statement 123(R)) describes situations when doing so may be possible, including those in which:
- “[T]he relationship between the stockholder and the corporation’s employee is one which would normally result in generosity (i.e., an immediate family relationship).”
- “[T]he stockholder has an obligation to the employee which is completely unrelated to the latter’s employment (e.g., the stockholder transfers shares to the employee because of personal business relationships in the past, unrelated to the present employment situation).”
Accordingly, a nonpublic entity should consider all facts and circumstances.
Transactions Directly Between a New Investor and the Nonpublic Entity’s Employees as Part of a Financing Transaction
As part of a financing transaction between a nonpublic entity and a new investor who is acquiring a significant ownership interest in the nonpublic entity, the new investor may repurchase common shares in the nonpublic entity from employees of the nonpublic entity. In this particular fact pattern, the investor did not participate in a prior financing arrangement and is purchasing convertible preferred stock from the nonpublic entity and common stock from the nonpublic entity’s existing employees. The price paid by the investor to purchase the preferred stock from the nonpublic entity and the common stock from the employees is the same. Although the new investor did not hold an economic interest before entering into the transaction with the nonpublic entity, the new investor is not dissimilar to a party who already holds an economic interest in the nonpublic entity and may have similar motivations to compensate employees.
As noted in ASC 718-10-15-4, a principle of ASC 718 is that a share-based payment arrangement between the holder of an economic interest in a nonpublic entity and an employee of the nonpublic entity should be accounted for under ASC 718 unless the arrangement is clearly for a purpose other than compensation for services. If a new investor purchases common stock valued at an amount based on the value of the preferred stock, we would generally expect the analysis to be similar to that applied when a preexisting investor purchases common stock from a nonpublic entity’s employees.
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