August 18, 2022

Secondary Market Transactions: What Companies Should Know About Accounting for Sales of Shares

By Itzel Martinez, Senior Accountant, Assurance Services

Secondary Market Transactions: What Companies Should Know About Accounting for Sales of Shares SEC Advisory

Private company shareholders are increasingly turning to secondary market transactions to monetize their shares before the company goes public or is sold. Accounting plays a critical role in these transactions, especially when it comes to determining whether the transaction triggers a recognition of compensation expense for the entity. This expense could be incurred when employees sell shares, or when the transaction involves non-employees who received shares in exchange for providing goods or services to the entity.

To determine if any additional disclosures are needed, consider the following:

1. The Nature of the Relationship Between the Seller and the Buyer

It’s important to consider the level of the employee (seller) involved in the transaction. If the current employee is high-ranking, the transaction could be interpreted as taking place on behalf of the entity — almost as if the entity is indirectly involved in the transaction. (See #3 for further examples of how the entity could be considered involved.)

If the employee has not been at the company for very long, it would indicate that any excess paid over fair value is not compensatory, though the characteristics of the buyer should still be analyzed.

On the buyer side, companies should consider characteristics like whether the new investor is a related party or if they hold an economic interest. This is especially important because if the buyer falls into either category, it could seem as if they are acting on behalf of the entity even if the entity is not directly involved. It’s also important to look at the significance of the interest held. If the interest is not materially significant, the presumption would be that the buyer is not acting on behalf of the entity; therefore, the transaction would be considered non-compensatory. That said, companies should still consider other factors, including whether the economic interest holder is a member of (or has a representative in) the board of directors. This could indicate that the economic interest holder is significant.

Note that entities repurchasing shares is a common secondary market transaction — and in this case, any excess over the fair value should be considered compensation cost.

Determining the relationship between buyer and seller is especially critical for entities that file for an initial public offering (IPO) or as a special purpose acquisition company (SPAC) with the Securities & Exchange Commission (SEC) because they may be required to disclose the transaction under the related party disclosure, depending the level of employees involved.

2. The Transaction Price and Surrounding Circumstances

If the transaction price is above fair value, the transaction could be considered compensatory and the entity would have to recognize the excess as compensation cost. Even though the price paid is above fair value, the entity should simultaneously consider its own involvement and the relationship between the buyer and seller. If the buyer and seller have a close relationship the transaction could be considered a gift or payment based on generosity, rather than compensation.

Entities must also evaluate whether the purpose of the excess amount paid over fair value is for something other than compensation. One question to ask is whether the entity is expected to benefit directly or indirectly. For example, the entity could benefit if the secondary market transaction settles agreements with former employees. Since the transaction benefits the entity, it could be assumed compensatory.

3. The Entity’s Involvement in the Transaction

Here are a few examples that show how the entity could be considered involved:

  • Connecting the buyers and sellers, or deciding which buyers or sellers are allowed to participate.
  • Negotiating a price or determining how many shares can be sold.
  • Providing a buyer with additional information that would not be available to regular shareholders.
  • Agreeing to alter the rights of the shares being sold, or creating a new policy that could favor new buyers.

By considering the important criteria above, entities can better assess the need for additional disclosures regarding compensation costs.