To, two. Through, threw. You, ewe – English doesn’t always make things easy. We’ve got countless words that sound the same but whose meanings are entirely different. Throw in some financial terminology and the confusion only mounts. That’s certainly true when it comes to defining fair market value (FMV) and fair value (FV) in equity.
Although these two terms sound similar, they are actually very different – and if you issue equity awards, the difference matters. To help you understand why, let’s look at each of these concepts in turn.
Fair market value and equity compensation
First off, we should start by saying that fair market value is used to calculate the value of a wide variety of assets – from real estate and stock to insurance policies and beyond. As an equity plan administrator, that means you may come across this term in multiple contexts, which just makes things more confounding.
For our purposes, let’s explore fair market value in relation to equity awards. In this case, FMV is tied to your company’s share price on a specific date, and it can be determined in a number of ways:
- If you’re a startup without a formal 409A valuation, your board of directors (or management team) will likely determine your share price – and consequently your FMV – either with or without the use of an established formula.
- Once you raise your first round of capital, and potentially face audit, you’ll likely need a formal 409A valuation, which determines FMV by establishing your share price at a particular point in time.
- For public companies, FMV is determined with reference to the stock’s market price, although policy dictates when that price is set (e.g., closing price, opening price, daily average).
No matter what calculation you use, establishing fair market value is critical for both tax and accounting reasons. For instance, if you plan to grant stock options to employees, board members, or as payment for services rendered to the company, FMV determines the price for your newly-issued equity. When an option is exercised, FMV determines the spread between the price at which it was issued and the price at which it was exercised. FMV is also used to determine the tax implications of a range of transactions, from the exercise of an option to the release of new stock.
All of which is to say, it’s pretty important to accurately calculate the fair market value of your shares.
Fair value of equity awards
When it comes to fair value – a calculation used for accounting purposes – you need to take more elements into account than just your share price. That’s because fair value is typically calculated in accordance with ASC 718, which requires companies that issue equity compensation to include a compensation expense on their income statements.
In recording this compensation expense for stock options, companies are expected to estimate the cost of their equity grants in relation to a range of variables. Suffice it to say that the calculation is sufficiently complex that most companies use a formal pricing model, such as Black-Scholes, to arrive at fair value. Without getting into the specifics, the Black-Scholes formula takes several inputs into account – including things like the option’s price and interest rate, volatility and the stock price, which just happens to be the grant date fair market value.
Yes, you read that right: your fair market value is one of the inputs used to calculate the fair value of your equity compensation. Just one more reason why these two terms are frequently confused.
Cutting through the complexity
Although it’s important to understand the difference between FMV and FV, it’s only a first step. As a private company, you’ll also need to calculate these different values.
If you’re looking for some help, Shareworks has you covered. Our team can help you develop a transparent and audit-ready 409A valuation that clearly sets your fair market value. With built-in Black-Scholes calculators, the Shareworks platform also enables you to meet your ASC-718 financial reporting requirements by using these calculations to determine your award’s fair value, and subsequently report on the total compensation expense for your equity plan.
To learn more, get in touch!