The popularity of issuing equity shares as part of employee compensation can be traced back to the mid-to-late-1990s dot-com boom when companies with big ideas but relatively little cash we’re able to recruit key talent with the lure of a possible future windfall.
At that time, barely a day seemed to pass without another shiny new tech startup arriving on the scene and excitedly competing for its 15 minutes of fame (and fortune). That boom proved – as they so often do – to be a precursor to a bust, and by 2002 many of those companies had exited the stage, having burned brightly but briefly. However, aside from being forever synonymous with the idea of spectacular gains and catastrophic losses in just a few years, another legacy of the dot-com boom era is how it ultimately triggered an overhaul in accounting practices relating to employee equity and stock-based compensation.
During that period when new tech startups seemed to emerge from around every street corner, accounting practices relating to the expensing of equity-based compensation had not been definitively standardized. It was not unusual for new companies, in their eagerness to appear as profitable as possible, to fail to recognize stock-based pledges as an expense at the time they were made. This tendency, in turn, created a messy situation in which it became difficult to accurately evaluate how companies were performing. With a view towards correcting this ambiguity, regulators eventually decided that there was a need to formalize the requirements around accounting-related reporting of employee equity and stock-based compensation.
This process began in the mid-2000s, with the introduction of the FAS1234R standards and obligations. These were subsequently reclassified in 2009 as Accounting Standards Codification Topic 718 – more commonly referred to as ASC 718. In the years since then, generally accepted accounting principles (GAAP) in the United States have come to regard ASC 718 as a standard methodology for handling employee stock-based compensation on an income statement.
What is ASC 718?
There are several steps you need to follow to adhere to ASC 718
So, what does ASC 718 entail? What reporting obligations does it place on companies?
The guidelines around these standards establish three basic steps for expensing an option:
- Calculate the fair value of the option.
- Spread the reporting of the expense associated with the option across its useful economic life.
- Recognize that expense as employee compensation on your income statement.
While the third step is self-explanatory, we need to take a closer look at the first two steps:
1: Calculate the fair value of the option
From the accounting perspective, establishing fair value at the outset is important, as doing so will let you know exactly what the option is worth and how it needs to be represented on an income statement.
For startups, options are illiquid assets (that is, they are not easily converted into cash), so the process of establishing how much they’re worth won’t necessarily be straightforward. Their value can’t be determined on the open market, and so instead a formal valuation model must be used.
There are many such models available, and businesses are free to choose which one they use, but you need to be consistent. So, once you choose an appropriate valuation model, you must then stick with it.
Whichever model you use, you will need to factor in a number of considerations, such as expected term, volatility, strike price, interest rate, dividend yield, and underlying value. When all relevant variables are fed into the model, this will yield a value per option figure which will then allow you to move on to the next step.
2: Spread the reporting of the expense associated with the option across its useful economic life
In an ideal world, we would be able to settle on a value per option using the approach outlined above, list the full amount as the relevant expense in the year the options are granted, and then get on with our lives without necessarily thinking very much about it again.
However, GAAP rules dictate differently.
Instead, the onus is on the company, for accounting purposes, to spread the expense across its useful life, which in this context means the vesting life of an option. So, in simple terms, if an option has a five-year vesting schedule, then the useful economic life of that option will be five years, and thus the expense associated with that option will need to be reported in each of those years.
The most straightforward way for this to play out might be as follows:
# Employee A has been granted 100,000 options.
# We establish using whatever model that the value per option is $0.20.
# Under a five-year vesting program, Employee A receives 20% of his options at the end of each calendar year.
# On that basis, we would allocate an expense of $4,000 for each of the five years (20,000 options multiplied by $0.20).
The above scenario showcases what is referred to as the “straight-line” method, whereby the expense is spread out evenly across the life of the option. Another approach, the FIN28 method, takes a different tack, instead of treating each of the vesting events associated with a particular options grant as a separate award. Under this latter approach, the shares due to vest in year one are allocated over one year, those vesting in year two are allocated over two years and so on, all the way up to those shares vesting in year five being allocated over five years.
All things being equal
When everything runs smoothly, the information detailed here sums up what is required under ASC 718 reporting. However, things won’t always run smoothly in the real world. Invariably, things will become more complicated at least some of the time. There is any number of ways in which this coherent flow can be disrupted, and when that happens, companies need to be able to react and tweak their reporting practices accordingly.
For example, a company may decide to reprice options if the exercise price is lower than the current fair market value. When this is the case, you must use modification accounting to remain compliant with GAAP. This approach requires the company to measure the value of an option before and after the change, and add any incremental expense to the expense already allocated, if necessary. It almost goes without saying that this process will become even more complicated in the event of multiple repricings and modifications over time.
Another key point to address is at what point should companies start recording employee options as an expense. It is not unusual for startups to choose not to do so, but as they move through funding rounds and the sums involved in those rounds grow larger, companies will generally make a point of becoming GAAP compliant, and this requires that ASC 718 guidelines be followed.
ASC 718 reporting will tend to become more complex over time and as such is a specialized task. This being the case, companies stand to benefit enormously if they look to bring in outside expertise as early as possible, rather than muddle through and become gradually or perhaps suddenly overwhelmed. Global Shares is here to help.
Contact us today and our team of highly qualified experts will be able to assist you through every step of the process.