The market for private company equity securities, often referred to as the "secondary market," continues to expand. Sales of employee shares to a third party in a secondary market transaction can introduce unique accounting challenges.

A purchase by a third party of shares from an employee or former employee, at fair value, is typically a transaction among shareholders, with no accounting recognition by the company. However, if the transaction price paid by the third party exceeds the fair value of the shares, the company will need to evaluate whether there is a compensatory element to the arrangement. In particular, if the company is involved in facilitating the transaction, it is likely that compensation expense will arise. Consideration of the extent of the company's involvement should include whether the company helped to arrange the transaction and whether it was concurrent with (or a condition for) a sale of other financial instruments by the company to the third party.

It is also important to understand the relationship between the company and the third party in the transaction. If the third party has a pre-existing economic interest in the company, the third party is presumed to be acting on behalf of the company as described in SC 1.4, and any excess of the purchase price over the fair value of the equity interest would be considered compensation to the employees for their services, unless the payment is clearly made for another economic benefit that the third party receives. The company would reflect the transaction as a contribution of the excess purchase price from the economic interest holder and payment of compensation to the employee or former employee. However, if the third party has only a de minimis ownership interest it may be reasonable to conclude that the buyer is acting independently rather than on behalf of the entity, and any excess of the purchase price of the shares or other equity instruments from the employee over their fair value may not be considered compensatory.

Secondary market transactions may also impact the classification of equity instruments or other share-based payment awards held by employees. As discussed in SC 3.3.3, a company’s history of repurchasing unexercised options or “immature” shares (shares in which the employee has not yet vested or has vested but which have been held for less than six months) could create a presumption that the company intends to settle future awards in cash, which would require liability classification for those awards. Whether a similar conclusion would apply to repurchases of equity instruments held by employees in secondary market transactions would depend on the relationship of the purchaser to the company and the underlying facts and circumstances of the repurchase transactions. We believe that secondary market repurchases by an outside investor would typically not create an in-substance liability arrangement, as the company is not using its own funds to settle the arrangement. In addition, absent other circumstances that indicate the company has arranged for the systematic or recurring repurchase by the same third-party investor of equity instruments held by its employees, typically these transactions would not be considered when determining whether the company has established a past practice of settling immature shares. However, it is important to consider the level of ownership of the economic interest holder. If, for example, the purchaser is a shareholder who holds all or the vast majority of the company’s equity, the substance of the repurchase may be that the economic interest holder is indifferent as to whether the company repurchases or the shareholder repurchases, and thus liability classification may be appropriate.