What is ASC 820?
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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.
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.
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.
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).