As a startup founder, you are likely focused on growth, innovation, and securing funding. While financial intricacies might not be your primary concern, understanding accounting standards like ASC 820 is crucial for your company's financial health.
ASC 820, also known as the 'Fair Value Measurement' standard, provides a consistent definition of fair value (of financial assets and financial liabilities), a framework to measure it, and requires detailed disclosure guidance about fair value measurements. This transparency is essential for investors and other users of the financial statements to understand your company's financial position.
ASC 820 is a wide-ranging standard that applies to any company that needs to measure or report the fair value by other FASB Accounting Standards Codification (ASC) topics. This blog covers the different facets of ASC 820, including its meaning, importance, fair value hierarchy, accounting guidance, valuation approaches, disclosure requirements and others. Keep reading to learn more.
What is ASC 820?
ASC 820 is a key accounting standard that mandates the reporting of investments at their fair value.It was created by the Financial Accounting Standards Board (FASB). This independent body sets the standards for public and private organizations in the US as per the Generally Accepted Accounting Principles (GAAP).
The principles and objectives of ASC 820 are centered around transparency and consistency. The standard aims to ensure that fair value measurements are reliable and comparable across different entities, from the perspective of market participants. It seeks to provide financial statement users with clear, concise, and meaningful information about the measurements.
ASC 820 categorizes assets into three levels based on their liquidity to determine their fair value. Level 1 assets, like publicly traded stocks, are easily valued due to their high level of activity and greatest market volume. On the other hand, Level 3 assets, such as assets with limited market data, pose a greater valuation challenge.
Who needs ASC 820 valuation?
ASC 820 valuation is crucial for a wide range of stakeholders. Understanding its importance can help you, as a startup founder, make informed decisions.
Investors: They rely heavily on ASC 820 valuations. Hedge funds, venture capital firms, and private equity companies use these valuations to assess the performance of their investments and manage their portfolios effectively. For instance, they need to determine the fair value of their holdings for financial reporting purposes and to make informed investment decisions.
Companies: Businesses best use ASC 820 valuations to estimate the value of employee stock options or pension obligations, and they require accurate fair value estimates. Additionally, companies often need to value assets or liabilities for mergers, acquisitions, or impairment testing.
Employees: They also benefit from ASC 820 valuation, as many companies offer employee benefit plans that include company shares or options. The fair value of these shares or options, determined according to ASC 820, is used to calculate the value of these benefits. This allows employees to understand the true value of their compensation package.
What is ASC 820 Fair Value?
The term fair value, as defined by ASC 820, is a market-based measurement, not a company-specific measurement. Fair value represents the exit price at which an asset could be bought or sold, or a liability settled, between well-informed and willing parties in an orderly transaction (at arm's length). The goal is to achieve an objective and unbiased valuation that accurately represents the asset or liability's worth in today's market.
This standard applies to many types of financial instruments, including financial instruments, retirement benefit plan investments, share-based payment transactions, and more. As the fair value is a market-based measurement, it reflects current economic conditions rather than historical costs.
Under ASC 820, several factors are considered in measuring fair value. These include the asset or liability characteristics, the market participant assumptions, the transaction's measurement date, the characteristics of the asset, the reporting entity, and the unit of account.
What is the Importance of ASC 820 Fair Value?
Here are the key concepts of ASC 820 that make it an essential part of your company's financial health and decision-making process:
Regulatory Compliance: Adhering to ASC 820 ensures compliance with the regulatory requirements set by the FASB. This compliance helps you avoid potential legal and financial penalties that could arise from inaccurate financial reporting or disclosures.
Financial Transparency: An accurate fair value measurement under ASC 820 enhances the transparency of your financial statements. It provides a clear and accurate representation of your company's financial position, making it easier for stakeholders, including auditors, to understand your company's assets, liabilities, and overall financial health.
Business Combinations and Impairments: ASC 820 is crucial in determining the value of your business and its assets. For example, when merging with or acquiring another company (business combinations), ASC 820 helps assess the deal's value. Additionally, it's essential to evaluate the worth of your company's assets and intangible assets (like goodwill) over time. This is particularly important when considering whether those assets have lost value (impairment).
Market Comparability: ASC 820 facilitates comparability across companies by providing a consistent framework for fair value measurement. This consistency makes it easier for investors and other stakeholders to compare your financial statements with those of different companies, aiding in investment decisions.
Risk Management: By measuring investments at fair value, ASC 820 reduces the risk of loss associated with investments and increases the certainty of potential profits. This can help you manage your company's financial risks more effectively, especially in the absence of a principal market.
Understanding the Fair Value Hierarchy of ASC 820
The ASC 820 Fair Value standard introduces a three-level hierarchy for classifying inputs used in the measurement of fair value:
Level 1: Quoted Prices in Active Markets
This level represents the most visible inputs to determine fair value. It includes the most liquid investments in an active market, such as the current quoted price for identical liabilities or assets.
For instance, publicly traded stocks or government bonds that are frequently traded in high volume would fall under Level 1. As per ASC 820, an active market is defined as a platform where the asset or liability is regularly traded, providing continuous information about the prices.
Level 2: Observable Market Data
This level consists of observable inputs other than the quoted prices included within Level 1. These could be identical assets or liabilities in markets that are not active.
Examples of Level 2 assets could include Over-the-counter derivatives, privately held company stock with limited trading, and real estate valuations based on recent comparable sales.
Level 3: Unobservable Inputs
This level includes assets or liabilities that are not observable as they are not frequently traded in the market, representing the lowest level of liquidity in the hierarchy. To ascertain the fair value of a Level 3 asset, all factors specific to the asset being valued must be considered, including market participant assumptions and interest rates.
For example, internally developed intangible assets, complex financial instruments, and private company valuations with limited market information would fall under Level 3.
Disclosure Requirements under ASC 820
Here are the key disclosure requirements under ASC 820 that you need to be aware of:
Valuation Techniques and Inputs: You are required to disclose the valuation techniques used and the inputs applied, both observable and unobservable, to measure fair value of financial instruments. The disclosure of these techniques and inputs helps stakeholders understand the methods used to determine the fair value of your assets and liabilities.
Fair Value Hierarchy Level: Each fair value measurement needs to be categorized within the fair value hierarchy as defined by ASC 820. This means you need to identify whether each measurement falls under Level 1, Level 2, or Level 3 of the hierarchy. This disclosure requirement helps stakeholders understand the liquidity and market activity of the assets and liabilities measured at fair value.
Changes in Valuation Techniques: If there are any changes in the valuation techniques used, you are required to describe these changes and the reasons for making them. This could include changes due to new market developments or improvements in the availability of data. Such disclosures ensure that stakeholders are kept informed about any significant changes in your valuation methods.
Sensitivity Analysis: For Level 3 measurements, you are required to provide a sensitivity analysis. This analysis should detail the potential impact of changes in the use of unobservable inputs on the fair value measurement. By providing this analysis, you can help stakeholders understand the potential variability in the fair value measurements due to changes in market conditions or assumptions.
How to Measure Fair Value According to ASC 820?
Determining the fair value of a company, according to ASC 820, involves a comprehensive understanding of the company's financial health and market position. Here are the important steps involved in the process of ASC 820 fair value measurement:
Determine the Enterprise Value of the Company
The enterprise value measures the total value of a company and is often used as a more comprehensive alternative to market capitalization. It includes the market cap along with short-term and long-term debt and any cash or cash equivalents on the balance sheet. There are three primary valuation methods to calculate enterprise value:
Income Approach: The income approach estimates the fair value of your business based on the present value of future cash flows. This method is ideal if your company has predictable cash flows and helps to capture your earning potential. It involves projecting the earnings of your business and then adjusting them for changes in growth rates, taxes, cost structure, and others.
Asset Approach: The asset approach values your company based on the fair value of individual assets and liabilities. This approach identifies your company's net assets by subtracting liabilities from assets. The asset-based valuation can be adjusted to calculate your company's net asset value based on the market value of assets and liabilities.
Market Approach: This approach relies on observable market indications to determine the enterprise value of the portfolio company. The market approach is often preferred for companies with limited long-term projection capabilities or those without any financing rounds within the last 12 months.
It includes:
The Guideline Public Company (GPC) Method involves identifying publicly traded companies with similar characteristics (size, revenue model, target market like your company. It then examines the implied multiples of relevant financial metrics to estimate the enterprise value of your business.
The Guideline Transaction Method follows a similar approach by examining recent mergers and acquisitions of comparable companies. Valuation multiples from these transactions are used to estimate the enterprise value of your company.
The Backsolve or Post-Money Valuation Method relies on the valuation determined in your company's most recent equity financing round as a basis for its value.
Allocate the Value Across all Share Classes
Once the enterprise value of a company is determined, the next step is to allocate this value across all share classes. This process is essential for accurately reflecting the value of each class of shares in your company. Let's analyze the different methods used for this allocation:
Common Stock Equivalent (CSE): The concept of Common Stock Equivalent (CSE) refers to a security that can be converted into common stock. These securities are treated as essentially the same as an equity issuance for trading purposes. The conversion occurs when a certain exercise price has been met or exceeded on the market. As long as the market price has been met, the security will be on par with common stock and can be converted without a loss.
Waterfall Method: This is a common approach to allocating profits among stakeholders in private equity and investment funds. It uses a 'waterfall' approach, which allocates the total value of a company to the various classes of investors (i.e., debt, preferred and common stock) based on each class's distribution rights in a hypothetical sale. This method is often used to determine the per-share value of common or preferred securities.
Option Pricing Model (OPM): The Option Pricing Model (OPM) is a widely used methodology for allocating equity value among different security classes within complex capital structures of privately held companies. This model posits that each security class can be considered a call option on the company's total equity value. To quantify this, the OPM often leverages the Black-Scholes model for option valuation. This approach is particularly suitable for companies anticipating a longer liquidity horizon and multiple potential exit strategies.
Challenges with ASC 820 Application
Applying ASC 820 can present several challenges, particularly for startup founders who are new to the complexities of financial reporting. Here are some common challenges you might face:
Complexity of Valuation: Valuing certain assets and liabilities, especially those that are not frequently traded in the market, can be complex. This complexity arises from the limited availability of observable market data and the need to rely on complex valuation techniques. For instance, valuing illiquid assets or making complex decisions often requires significant management judgment.
Subjectivity in Level 3 Inputs: Level 3 inputs are the most subjective and least observable inputs in the fair value hierarchy. These inputs require significant management judgment and may include assumptions about future cash flows, discount rates, and other factors that are not directly observable in the market. The use of such unobservable inputs introduces a greater level of subjectivity and potential variability in the fair value estimation process.
Keeping Up with Market Changes: Fair value measurements need to reflect current market conditions. This needs ongoing monitoring and updating of the measurements, which can be challenging, especially in volatile markets. For instance, the fair value of an asset or liability can change significantly due to market fluctuations, requiring frequent revaluations.
Compliance and Audit Readiness: Ensuring compliance with ASC 820 requires maintaining thorough documentation and audit trails. This includes documenting the valuation techniques used, the inputs applied, and any changes in these techniques or inputs. Maintaining such extensive records can be challenging but is crucial for facilitating audits and ensuring regulatory compliance.
Conclusion
Understanding and complying with ASC 820 is crucial for accurate financial reporting. It provides a consistent framework for measuring fair value and requires detailed disclosures about these measurements. As a startup founder, understanding the complexities of ASC 820 can help you navigate the financial landscape with confidence.
At Qapita, we understand the complexities of fair value measurements and disclosures. Our platform offers an extensive range of services to help manage your equity matters efficiently. From CapTable management and equity awards to advisory and consulting, our platform is designed to simplify the management of ownership in your company.
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As you continue your journey as a startup founder, remember that understanding ASC 820 and managing your company's fair value measurements and disclosures are key to your financial success. Our experts are here to help you every step of the way.
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