Equity plan stock valuations

Dan Patracuolla and PJ Viscio of Duff & Phelps discuss the valuation of a portfolio company's stock for purposes of the portfolio company's own financial statements. An excerpt from The Definitive Guide to Private Equity Valuation: An in-depth A-Z guide to valuing investments fairly, a new book from PEI Media.

Of the various additional applications of fair value, the one likely to have the most significance is that of the valuation of a portfolio company’s stock for purposes of the portfolio company’s own financial statements.
Where required, these types of valuations are generally performed at least annually, with more frequent bases (including quarterly) becoming more prevalent. Typically it is the board of directors or the compensation committee that has the responsibility for setting ‘fair value’ as defined in the underlying agreement governing the option plan. The ‘fair value’ is utilized for setting the exercise price of options granted to management and employees as well as a buy/sell price for participants entering or leaving the plan. Additionally, these valuations have potential financial reporting and tax reporting implications under FASB ASC 718, IFRS 2 and IRC 409A, respectively.
The overarching implication of these valuations stems from the fact that the portfolio manager (general partner or GP), who establishes ‘fair value’ of the portfolio investment at the fund level may also be signing off on the ‘fair value’ of the stock through participation on the board of directors. It is in these instances where there is the potential for an asset manager to give approval to two different valuations that may not be consistent with each other.
Identical versus consistent
Do two different valuations as of the same date need to be the same? The short answer is that they should be consistent, i.e., reconcilable. While the valuation of the portfolio investment may typically consider the exit value for a control position (if indeed the ownership, the valuation of the stock is done on the basis of a single share consistent with the requirements of the plan. There is a diversity of practice where some plans require the shares to be valued as a pro rata portion of a control position while others require value to be determined in a manner that takes into account the minority/illiquid status of the shares. (Either way, the value at some point would need to be reported in a manner consistent with the requirements of FASB ASC 718.) Thus while two valuations may be based on the same underlying enterprise value, differences in control/illiquid-minority status, stemming from differences in the nature of the subject being valued and unit of account and resulting in a discount being applied to the value of a single share, would result in different reported values.
There are additional factors that would lead to different indicated values at the enterprise level. For instance, the value of the portfolio investment would be based on a hypothetical exit price for the investment and would reflect, within the discount rate, the assumption that a market participant would utilize an efficient capital structure to finance the transaction. On the other hand, the value of the single share of stock does not take into account a control exit (unless, of course, the control exit is imminent) but would take into account the actual leverage of the company (impacting the discount rate), as well as the anticipated deleveraging of the business through appreciation, debt repayment, and eventual exit of the investment within an assumed timeframe.
This valuation nuance stems from the difference in nature of the valuation subjects, their units of account and the definition of value itself (i.e., ‘exit price’) under FASB ASC 820. While it would account for a certain level of reconcilable difference in enterprise value, under ordinary conditions it would not be expected to lead to significant differences in enterprise value.
Additionally, the required premise of value, for both financial reporting and tax reporting, for employee grants of stock-based compensation is on a standalone basis. The stand-alone premise of value relates solely to the existing operations of a company and does not consider any value related to potential synergies that may be achieved on a combined/integrated basis. This stands in contrast to the ‘market participant’ concept in a fair value context and the ‘willing buyer’ concept in a fair market value context where the value of potential synergies are generally considered.
This passage is excerpted from The Definitive Guide to Private Equity Valuation: An in-depth A-Z guide to valuing investments fairly, a new book from PEI Media. Primarily written by valuation experts Duff & Phelps LLC, this guide provides investors and fund managers with valuable tools and practical guides to fairly value nuances and scenarios, as well as case studies and best practices. Sample contents and more information on the book are available here.