The Not-So-Great Smaller Reporting Company Fair Value Debate

My favorite question from clients that doesn’t appear to have a good answer, despite what we generally tell them, is “How do we account for this note payable that we just issued along with shares of stock?”  The simple non-useful auditor answer – “just account for the transaction at its fair value.”

This answer has sparked seemingly endless discussion amongst the team members in our firm along with our clients which we fondly refer to as the “Circle of Hate” discussions.  Consider the following example:

Company X issues a three year $100,000 note payable with a stated interest rate of 15% in a private placement transaction.  In order to get interest from potential investors, the Company also issues 1,000,000 shares of Rule 144 restricted common stock.  The quoted market price on the issuance date is $0.15 and the average daily trading volume is 5,000 shares.  Again, the question is what is the value of debt on the issuance date, and how does that value change as time passes through maturity?

Scenario 1

Probably the most popular amongst small issuers that I have seen, although not without significant flaws, is to value the shares first into APIC and assign the corresponding discount to the debt and begin accreting the debt.  The flaws(issues) with this methodology in the example above are significant.  Strictly adhering to the Level 1 input of the quoted price (in this example assume under GAAP the quoted market price is the most reliably measurable) the discount on the $100,000 debt is $150,000.  This leaves what we refer to as the “floating debit” of $50,000. 

Now what to do with the $50,000 has been of great internal debate with seemingly no winning choice.  The apparent precedent amongst issuers is to cap the value at the proceeds received of $100,000, ignore the remaining $50,000, and begin accreting the debt from zero.  One major problem with this approach is there is not a way to calculate an effective interest, as required by GAAP, to accrete from zero.  Issuers, however, seem to get around this by disclosing the following “we amortize the debt discount over the life of the loan using the straight line method which approximates the effective interest method”.  Since there really is not a way to calculate the effective interest rate I am not real sure how this can be the case, but seems to be working for several issuers.

A second option that does not appear to make sense, is to book the $50,000 as a prepaid loan cost of some sort and amortize it over the life of the loan.  Again, there appears to be some GAAP basis in that debt issuance costs are required to be amortized over the life of the loan.  This methodology just doesn’t pass the smell test.  Why?   The issuer has a $100k obligation which does not initially appear on its balance sheet, but $150k in assets($50k of which doesn’t generally meet the definition of an asset), $0 liability, and $150k increase in capital.  I can’t think of a way to make entering into a financial obligation look any better.

Another popular strategy, although difficult to support in most instances, is to discount the quoted market price of the stock.  Most issuers that I have had discussions with generally have great common sense arguments, but no clear GAAP basis or assumption / model development for such discounts.  Most arguments are something along these lines “if they try to sell 10,000,000,000 shares tomorrow when the average daily volume is 5,000 it will drive down the price”, therefore, a marketability and blockage dicount of XX% is appropriate, not to mention the stock is restricted under Rule 144.  The problem many issuers face is developing supportable assumptions for the XX% discount.  It would be nice to apply recently issued accounting literature related to inactive markets and non-orderly transactions, however, that guidance indicates various factors need to be considered – not how to apply them to fair value models.

Scenario 2

Estimate the fair value of the debt first and assign the remaining fair value to the stock issued.  Again there are significant difficulties in developing a supportable fair value with this methodology.  The first of which is determining an appropriate effective interest rate.  Since the Company in the example does not have, nor has it ever had, the ability to obtain financing without significantly sweetening deals with equity or other equity linked instruments there is not an internally comparable rate to base it on.  Also, other companies within its industry having similar traits are experiencing the same problem so there really isn’t any available Level 2 surrogate.  This leads to Level 3 inputs at best with little guidance on how to develop assumptions.

Scenario 3

Basically a hybrid of the above 2 not-so-great techniques.  Estimate the relative fair value of each component then develop a supportable basis to allocate the value of the total package.  This has the same issues as Scenario 1 and 2, but at least the Company has presumably considered each possibility.

Scenario 4 

Take the entire $100k from the note issuance and spend it on a valuation expert to “properly” account for the transaction.

All thoughts and comments on how to break the “Circle of Hate” are welcome and encouraged.