What is ASC 820?

Before a startup goes public or is acquired, determining its valuation can be challenging. 

However, for founders and CFOs, it’s important to know how to assign a fair value to the company’s equity, especially when reporting to investors, issuing stock options, or preparing for audits.

This is where Accounting Standards Codification Topic 820 (ASC 820) comes in. It is the accounting rule that defines how to measure the fair value of investments. 

What is ASC 820?

ASC 820 is a set of guidelines developed by the Financial Accounting Standards Board (FASB) to provide a standardized approach for measuring and reporting the fair value of assets and liabilities in financial statements. The standard is part of the Generally Accepted Accounting Principles (GAAP) but is also designed to align with International Financial Reporting Standards (IFRS).

Before ASC 820, there were no standardized guidelines for determining fair value, resulting in inconsistencies and subjective valuations. This lack of clarity played a role in financial scandals like Enron, says Mansour Farhat in one of his explainer videos. 

ASC 820 defines fair value as the price at which an asset could be sold or a liability transferred. 

It outlines a framework with a three-level hierarchy of inputs—Level 1, Level 2, and Level 3—that helps determine the most reliable valuation for assets and liabilities.

The goal with this framework is to ensure transparency and consistency in how companies assess and disclose the value of financial instruments.

Why do I need an ASC 820 valuation?

ASC 820 is a broad accounting standard for measuring fair value in financial reporting, which can be applied to a wide range of situations:

1. To value private companies

Venture funds and private equity firms rely on ASC 820 valuations to determine and report the fair value of their investments.

These valuations are critical for periodic reporting to limited partners (LPs). ASC 820 ensures firms meet accounting standards and maintain consistent valuations, which is vital for audits, raising capital, or planning exit strategies such as acquisitions or IPOs.

2. To issue stock options or other equity compensation 

As a company, if you're offering stock options to employees, contractors, or founders, you'll need a 409A valuation (which is based on ASC 820 principles). This valuation determines the fair market value (FMV) of your company's common stock to set a legitimate exercise price for stock options. 

3. To raise capital 

If you're raising funds from investors, they might request a fair value assessment of your company.

While ASC 820 outlines how to determine fair value for financial reporting, investors may seek a specific 409A valuation to ensure it accurately reflects the company’s fair market value as perceived by the broader market.

4. For financial reporting and auditing

If your startup needs audited financial statements, you may need to use ASC 820 to report the fair value of assets and liabilities on your balance sheet.

This is important when dealing with convertible debt, mergers and acquisitions, or complicated financial structures.

The three ASC 820 levels/ fair value hierarchy

ASC 820 establishes a fair value hierarchy that categorizes the inputs used in valuation techniques, prioritizing observable data over unobservable assumptions.

The hierarchy consists of three levels of inputs, each reflecting varying degrees of reliability.

‍Level 1: Quoted prices in active markets

Level 1 inputs are the most reliable for fair value measurement. They are based on quoted prices for identical assets or liabilities in active markets.

For example, publicly traded stocks or bonds where you can directly observe the market price.

The assets and liabilities that fall into this category are the most liquid.

Level 2: Inputs other than quoted prices in active markets

This level uses observable data that isn't directly quoted for the specific asset but is derived from other observable inputs. This can include prices for similar assets in active markets or data from less liquid markets, like bonds or derivatives.

Level 3: Unobservable inputs

Level 3 inputs are based on data that is not directly available from the market and often require estimation or judgment. These inputs are typically used when valuing private companies or startups, where there is no clear market price. 

For example, methods like discounted cash flow (DCF) models use projections about the company’s future cash flows, growth rates, and risks to estimate value.

Level 3 assets and liabilities are the most illiquid.

ASC 820 fair value measurement

To measure fair value under ASC 820, the process generally follows two primary steps: 

Step 1: Calculate the company’s enterprise value

The first step is to estimate the enterprise value (EV) of the company, which reflects its total worth, including equity, debt, and cash.

For publicly traded companies, enterprise value is calculated as the market capitalization plus total debt, minus cash and cash equivalents.

We add debt because in the event of an acquisition, the buyer assumes ownership of the target company, which includes its financial obligations as well. If the company has any outstanding debt, the acquirer is responsible for paying it off.

Adding debt to the calculation ensures that the enterprise value represents the actual amount the acquirer will need to settle as part of the total cost of acquiring the company.

However, for private companies (Level 3 assets), the process of calculating enterprise value differs. 

The three main approaches used to determine enterprise value for them are:

1. Income approach (Discounted cash flow)

This method is best for companies with predictable cash flows or those nearing profitability. It estimates the present value of future cash flows that the company is expected to generate.

The discounted cash flow (DCF) analysis calculates future cash flows and discounts them by an appropriate rate (often the company’s weighted average cost of capital, or WACC).

2. Market approach

This approach relies on observable market data to determine enterprise value. It is helpful when a company has limited cash flow history or comparable market players. 

Common methods within this approach include:

Guideline Public Company Method (GPC): Compares the company to publicly traded firms with similar size, revenue, and business model, using multiples of revenue or EBITDA.

Guideline transaction method: Looks at recent mergers and acquisitions (M&A) involving similar companies.

Backsolve/post-money valuation method: Uses the valuation implied by the company’s most recent financing round.

3. Asset Approach

This method calculates the value based on the company’s net assets (assets minus liabilities), and is typically used for early-stage companies that have limited revenue or cash flow but valuable assets.

Step 2: Allocate the enterprise value across share classes

After determining the enterprise value, the next step is to allocate that value across different share classes (e.g., common stock, preferred stock). 

There are several methods used for this allocation:

1. Waterfall method

The waterfall method allocates value based on the rights and preferences of each share class.

The waterfall method works well for companies nearing an IPO or acquisition because it reflects how the value of the company will be distributed to shareholders during these events. 

2. Option Pricing Model (OPM)

In the Option Pricing Model (OPM), instead of just looking at the current value of shares, each type of share (like common or preferred) is treated like a "call option." A call option is essentially a right to buy something at a certain price in the future.

In this case, it means that each share has a certain value based on the potential future events of the company, like an IPO or acquisition. The OPM looks at things like the likelihood of these events, market volatility, shareholder rights etc.

This method works well for startups or early-stage companies because their future is uncertain and could have many possible outcomes. The OPM helps divide the company’s total value among different types of shares based on the probability of these events happening.

3. Probability-Weighted Expected Return Method (PWERM)

PWERM evaluates potential future exit events (like an acquisition or IPO) and assigns probabilities to each based on their likelihood of occurring. It then calculates the value of each potential outcome, weighted by these probabilities, making it ideal for situations where a company is nearing an exit event with a defined timeline.

While OPM is designed to handle broader, longer-term uncertainty about exits, PWERM is focused on specific, near-term exit events

4. Common Stock Equivalent (CSE)

The Common Stock Equivalent (CSE) method assumes that preferred shares are converted into common shares and allocates value based on this assumption, disregarding any liquidation preferences. 

What is the difference between ASC 820, a 409A valuation, and the black-scholes model?

ASC 820 provides a framework for measuring the fair value of assets and liabilities and reporting them in financial statements.

A 409A valuation is a specific application of fair value measurement used to determine the fair market value (FMV) of a company’s common stock. This valuation ensures that stock options are issued at an appropriate price, complying with IRS regulations.

The black-scholes model is often used within the context of a 409A valuation to determine the value of stock options. It’s a mathematical model that calculates the theoretical value of options based on factors like stock price, strike price, volatility, time to expiration, and interest rates. 

In short, while ASC 820 sets the overall framework for fair value measurement, a 409A valuation applies this framework specifically for stock options, and the black-scholes model is one tool used in that process to value those options.