What Is ASC 820? A Guide to Measuring Fair Value
Say you manage a large investment portfolio at a venture capital firm. In this scenario, you probably care a lot about tracking the value of each of your portfolio’s investments over time. After all, this is the only way you can make knowledgeable, up-to-date decisions about your investments and explain those decisions to your firm’s limited partners (LPs) with any sort of confidence. But how do you actually measure the value of your investments? The answer to this question involves an accounting standard known as ASC 820.
ASC 820 requires that assets and liabilities be reported on financial statements at fair value. Fortunately, it also lays out a framework for classifying the different inputs needed to calculate fair value. This ensures a higher level of consistency and comparability between fair value measurements.
But ASC 820 isn’t just something investors need to worry about—founders, employees, and others may also use a company’s ASC 820 valuation for different purposes. In this guide, we’ll review the basics of ASC 820, from how it classifies different types of assets to who actually benefits from an ASC 820 valuation. We’ll also cover some aspects of the ASC 820 fair value measurement methodology, including the different valuation methods that may be used under ASC 820.
- What is ASC 820?
- Who benefits from an ASC 820 valuation?
- Understanding ASC 820 fair value
- What is the fair value hierarchy?
- Steps to measure fair value using ASC 820
- Track and manage your full equity picture with Pulley
What is ASC 820?
ASC 820 is an abbreviation of Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 820, which pertains to the issue of fair value measurement. The basic purpose of ASC 820 is to clarify and standardize the process of valuing assets and liabilities, so as to ensure that investments are reported at their fair value.
You may be wondering, “Is it really so difficult to measure the fair value of an asset or liability? Do we really need a whole accounting standard for it?” Well, let’s think about that for a second. Not all assets and liabilities are the same, and with some it’s much easier to determine the value than with others. For example, it may be quite easy to establish a fair market value for shares traded on a public stock exchange, where assets are highly liquid and frequently traded. But it may be far more difficult to determine how to value a relatively illiquid asset, where you don’t have the same observable market inputs.
ASC 820 addresses this issue with a fair value hierarchy that standardizes how assets are valued based on their level of liquidity. There are three levels in this hierarchy; a Level 1 asset is one that’s highly liquid (i.e. a publicly traded stock), while a Level 3 asset is one that’s far less liquid (i.e. a complex derivative product). The basic idea behind this framework is to get at a valuation of an asset that’s based on the price that asset would be worth on the open market, even in cases where that’s not exactly easy to measure.
We’ll break down exactly how ASC 820 works in a bit, but first it’s important to note that ASC 820 doesn’t exist in a vacuum. It’s part of a wider framework of U.S. accounting standards created and maintained by an organization called the Financial Accounting Standards Board (FASB). To understand how this all fits together, let’s take a look at Generally Accepted Accounting Principles (GAAP) and the FASB’s role in maintaining them.
What is GAAP?
Generally Accepted Accounting Principles (GAAP) are a set of accounting standards that help to promote consistency and comparability in financial reporting across U.S. companies. U.S. GAAP guidance promotes a common set of principles that makes it much easier for investors and other interested parties to figure out what’s going on with the financials of the companies that compose their investment portfolios.
Publicly traded companies are required to be GAAP compliant, but private companies aren’t. Many startups don’t put in the work to get GAAP compliant until a Series B or C financing round, when an eventual path to an IPO or acquisition starts to crystallize a bit. Being GAAP compliant (or at the very least semi-compliant) has its benefits in terms of financing, as many investors in post-seed financing rounds find it easier to evaluate a company’s financials if they’re basically in accordance with GAAP.
The organization that creates and maintains GAAP accounting standards is called the Financial Accounting Standards Board (FASB). This same organization is responsible for publishing a set of guidelines called the Accounting Standards Codification (ASC), of which ASC 820 is a part.
What is the Accounting Standards Codification (ASC)?
Since the FASB published the Accounting Standards Codification (ASC) in 2009, the codification has served as an exhaustive source of GAAP standards. Each of its constituent principles is broken down into an individual topic and given a number.
ASC Topic 820, or simply ASC 820, is one of these numbered topics.
Who benefits from an ASC 820 valuation?
All of this may sound a bit tedious, but accurate financial reporting matters! This is true whether you’re an investor, a startup founder, or even an employee.
If a venture capital or private equity firm invests in a number of different startups, it’s important that they know the fair value of each of the investments in their portfolio. This can help them make more knowledgeable decisions, especially since the values of different investments may fluctuate between reporting periods.
Similarly, it really helps a company do business when it has a clear way of determining the value of its investments and assets. The company can, for example, make more informed decisions about employee benefits and compensation. Speaking of employees, employee benefit plans need a way to measure and report the fair value of their investments—which is something many employees are keen to understand.
Understanding ASC 820 fair value
Before we dive into the ASC 820 fair value hierarchy and different methods for calculating fair value under ASC 820, it probably makes sense to clarify what we mean by “fair value.” In this context, fair value refers to the price that will be received to sell an asset or paid to transfer a liability. ASC 820 also specifies that the exchange must be an orderly transaction between market participants, and it must take place on the specified measurement date. The price under these conditions is also known as the exit price.
What is the fair value hierarchy?
ASC 820 creates a three-level hierarchy of financial assets and financial liabilities for the purpose of classification. Generally speaking, this hierarchy breaks down along lines of liquidity. The more liquid an asset, the higher-up its place in the hierarchy. The most liquid assets are classified as Level 1, while the least liquid assets are classified as Level 3.
How a financial instrument is categorized within the fair value hierarchy aligns with the lowest level that’s significant to the fair value measurement. In other words, Level 1 inputs are the highest priority and should be used when possible.
Level 1 (most liquid)
Among all classified assets and liabilities, these are the most liquid. This generally means that, on the date of measurement, there are quote market prices in active markets for identical assets or liabilities. For example, public exchange-traded shares would likely be classified as Level 1 because the price of a share is quoted in an active market.
Level 2 (less liquid)
Level 2 assets and liabilities are less liquid than Level 1 and more liquid than Level 3. While it may be difficult to find quoted prices for an identical asset or liability in active markets, it might be possible to find prices for something similar. (Or, one might look in markets that aren’t active for a reference point). One may need to observe inputs other than quoted prices to arrive at a valuation for a Level 2 asset or liability. Examples may include credit or interest rate swaps.
Level 3 (highly illiquid)
Level 3 assets and liabilities are trickier, because they’re typically no market data nor other observable inputs you can use to assess their value with any degree of accuracy. In general, the inputs for these valuations reflect management's best estimates and assumptions of how market participants would price the assets or liabilities on the date of measurement. Examples may include certain foreign stocks, complex derivative products, or private equity shares in an early-stage startup whose valuation is based at least partly on unobservable inputs.
Steps to measure fair value using ASC 820
So far we’ve defined a lot of terms and provided a lot of context, but the question remains: how does one actually use ASC 820 to measure fair value? There are, generally speaking, two primary steps for doing so:
1. Calculate the company’s enterprise value
The first step in the process is to determine the enterprise value of the company. This enterprise-level calculation can then be used to determine how the value is allocated across share classes.
There are three different valuation techniques you can use to arrive at a calculation of the overall value of the company, and which approach you choose may depend on a number of factors. Let’s take a look:
- The income approach (a.k.a. capitalized cash flow analysis). This approach is generally best for businesses already generating a cash flow, because it involves estimating the present value of cash flows expected to be generated in the future.
- The market approach. As its name suggests, this approach involves an evaluation of observable general market conditions to arrive at a company’s enterprise value. For example, you might look at publicly traded companies of comparable size, revenue, and target market/audience (this sub-approach is called the guidelines public company method and involves a number of assumptions). Other variations of the market approach involve looking at recent M&A deals for comparable companies, or using figures from the company’s most recent financing round to arrive at a reasonably accurate valuation.
- The asset approach. This approach essentially locates the value of the company in the total value of its assets. Simple enough, which is why earlier-stage startups without much cash-flow or comparable-company data to reference may opt for this method.
2. Allocate the resulting value across all of the company’s share classes
The next and final step in this process is to take the enterprise value you arrived at in Step 1 and allocate it across all of the company’s share classes. As in the previous step, you have some different methods for how to do this.
- The waterfall method. Among the more complex (and artfully named) methods of the bunch, the waterfall method allocates value based on rights and preferences of every stakeholder in the company’s cap table. A waterfall approach could make the most sense if the company is nearing an acquisition or IPO.
- The option pricing model (OPM). This method essentially treats each share class as a call option on the overall equity value of the company. It may use a model such as the Black-Scholes model to account for factors such as market volatility and time to liquidity.
- The probability-weighted expected return method (PWERM). It’s not the most elegant acronym, but PWERM can be another method to consider for companies expecting a short period of time between the date of the valuation and a potential future liquidity event. This is because PWERM is concerned with evaluating a range of specific future outcomes, and as such it requires you to make some more specific assumptions about what those outcomes might be. PWERM factors in and weighs those outcomes based on their probability of actually happening, then allocates the value to each share class based on the rights and terms of different shareholder agreements.
- The common stock equivalent. This method first assumes that preferred shares of stock are converted into common shares, then allocates a value for all shares. Unlike the methods discussed above, it doesn’t account for the various rights and preferences some shareholders may be entitled to.
Track and manage your full equity picture with Pulley
There’s really no getting around it: the process of valuing your company’s assets and liabilities can be confusing, and at a certain level it can make sense to bring in a professional valuation specialist to help you out. One approach you may not want to take is to lean hard on spreadsheets and other manual tools to get the job done, because there are better (and less error-prone) solutions out there. Like Pulley!
Our plans offer a great solution for startups of any size, with pricing and features that scale with your team. Whether you’re looking to prepare for investors with a 409A valuation and accurate cap table or you’re ready to start modeling complex fundraising rounds, Pulley has your back. Schedule a call with one of our experts today and learn how we can help.
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