Profitable investments are the financial core of every business, and such investments depend largely on business value. This value is also critical in negotiations and for building accurate financial reports. The ASC 820 fair value comes into the picture here and is helpful when keeping LPs (limited partners) abreast of any investment updates. We will take you through the ASC 820 in detail below.
Definition: ASC 820
Listing company assets and liabilities is relatively complex, given that the value of said assets and liabilities constantly fluctuates with changing market trends.
Consequently, determining the valuation of company holdings is cumbersome. However, this was simplified when the Financial Accounting Standards Board (FASB) issued the ASC 820 in 2018.
The ASC 820, also known as the Fair Value Measurements and Shareholding Disclosure, is an accounting standard that defines fair value and the framework within which it should be determined.
It guides in line with Generally Accepted Accounting Principles (GAAP) and is beneficial in assessing asset value for each financial reporting period.
ASC 820: Understanding Impact and Importance
Earlier FASB standards involved complicated processes that overstated asset and liability values. In addition, reporting requirements were tedious, and the reports themselves were not very useful.
The ASC 820 brings clarity in reporting to the cap table, as well as a shift in focus. Namely, greater weight is given to the value an asset would fetch in the market instead of its purchased value.
This is particularly useful since assets and liabilities are evaluated based on their current market values, increasing disclosure requirements. In addition, ASC 820 is efficient, even in complex cases involving highly illiquid assets.
Breaking Down the Liquidity Hierarchy
The ASC 820 is advantageous in its classification of assets based on liquidity. This is helpful since the more liquid an asset is, the easier it is to determine its value. Additionally, this standard also applies to liabilities, determining the price paid to transfer this liability at fair value.
We detail the levels of the hierarchy below:
Level 1 assets & liabilities
Level 1 assets are liquid and liable, whose values are easily determined. Common examples include publicly-traded stocks and money-market funds.
Level 2 assets & liabilities
These assets and liabilities are not as readily priced as Level 1 but are not as esoteric as Level 3. Level 2 asset and liability prices can be determined by extrapolating available data, such as market prices of other equivalent assets and even interest rate swaps.
Level 3 assets & liabilities
Level 3 assets and liabilities are highly illiquid, and market data is elusive. This is what makes determining their price such a difficult task. Common examples include foreign stocks, equity shares, and preferred stock in a company.
Carrying out the Valuation
The ASC 820 requires that companies use available market data for all valuation methods, and in their absence, they encourage the usage of models based on market data.
Below, we detail exactly how to value a company’s holdings:
Step 1: Calculating the overall value
Calculating the enterprise value entails estimating its total worth, including cash and other assets, equity, and liabilities. There are various ways a company can go about this, as presented below:
Methods of evaluation
- The income approach: This method is favored by established businesses that routinely generate profits. The method itself hinges on applying a cash flow analysis to predict future net present value cash flows, appropriate for established businesses.
- The market approach: Companies can establish a valuation based on the valuations of similar companies or their most recent rounds of funding.
- The asset approach: This approach is a favorite amongst early-stage companies that aren’t yet generating revenues due to its simplicity. It entails simply tallying up the net assets of the company.
Step 2: Allocating value
Now that the valuation has been decided, it is essential to allocate this value across all share classes. As with determining values, there are also multiple methods of allocation:
Methods of allocation
- Waterfall: This is suitable for companies likely to be acquired soon or have complex cap tables since the allocation accounts for different shareholder rights and preferences.
- Option pricing model (OPM): This method also considers shareholder rights and preferences, market volatility, and exit timelines. It is helpful for young companies without much clarity regarding the same.
- Common stock equivalent (CSE): CSE is preferred by companies heading towards an IPO since it works under the assumption that all preferred shares are now common shares. Consequently, it allocates values to all equity holders.
- Probability weighted expected return method (PWERM): PWERM is a forward-looking method that defines and analyzes future exit events’ outcomes. Values are allocated to each share class based on this.
How Can trica equity Help?
Determining appropriate fair values entails complex calculations and depends on reliable and accurate equity-related information. In addition, poorly designed and disorganized cap tables render the process cumbersome.