With the war for talent at a fever pitch these days, stock-based compensation (SBC) is one of the most effective ways for private companies to attract and retain valued workers. It’s also a very effective way for early-stage companies and other private entities to preserve cash flow while allowing key employees to share in the company’s growth. But the SBC accounting rules and calculations can be complex.
While FASB and the Private Company Council
When private companies must treat employee SBC awards as an expense
Having worked with many technology startups and other early-stage companies, I can’t tell you how often I see their accounting for SBC awards overlooked. By the time they start raising larger funding rounds — typically in the Series A or B round — they typically need to be audited and must become GAAP compliant. That’s when the fire drill starts, since most private or early-stage companies do not have adequate resources in-house to handle complex GAAP accounting and financial reporting for SBC awards. That can be problematic since larger investors typically want a third party to sign off on the accuracy of the startup’s financials. They want assurance that the company is not doing anything fraudulent or failing to follow generally acceptable accounting guidance. Also, when private companies are cavalier about their SBC accounting in their early years, it can be costly and time-consuming to change from non-GAAP to GAAP standards as they prepare for an IPO, sale or other exit. Trust me, I’ve been there, done that, and it’s not fun.
Below are important SBC accounting considerations, no matter where a company is in its evolution:
1. ASC 718: Any U.S. entity (following GAAP) that provides SBC to its employees, contractors, advisors and legal service providers, etc. is required to account for SBC in accordance with Accounting Standards Codification (ASC) Topic 718 (Compensation – Stock Compensation). Common types of SBC subject to ASC 718 include stock options, restricted stock units (or RSUs), stock appreciation rights (SARs), phantom stock plans and profits interest. Similar awards with certain characteristics may require an in-depth analysis to determine whether they need to be accounted for as SBC under ASC 718. Such awards may include profits interest (with certain characteristics, to be discussed further below), profit-sharing arrangements and cash-deferred compensation plans.
a) Incentive stock options: Generally speaking, an ISO is a stock option that can only be granted to an employee and that does not result in any employee income (or employer deduction) at exercise, unless there is a “disqualifying disposition” or a sale of the underlying purchased shares within one year of acquisition. An employee who’s been granted an ISO has the option, but not the obligation, to purchase vested shares of the company’s underlying equity (e.g., common stock) at a predetermined price, or strike price within a set time frame — typically 10 years from the grant date.
b) Non-qualified stock options: An NSO is a stock option that does not meet the ISO requirements (see above), and if exercised, the employee, vendor or director holding it will have compensation income equal to (and the employer is entitled to a deduction for) the difference between the fair value of the stock at the time and the exercise price.
c) Restricted stock: A restricted stock arrangement is one in which an employee is granted stock that is subject to a vesting requirement and is nontransferable at the time of grant. While the stock is restricted, the employee may have dividend and voting rights (or the dividends may be reinvested or paid at vesting). When the restrictions lapse, the employee has compensation income equal to the value of the stock (less any amount they have paid for the stock) under IRC Section 83. Alternatively, the employee may be entitled to make a “Section 83(b) election” and be taxed based on the value of the restricted stock at the time of grant. This enables the employee to convert subsequent appreciation from ordinary income to capital gains.
d) Stock appreciation rights: SARs give an employee the right to receive the value of stock appreciation, payable in shares or in cash, without having to tender an exercise price. Sometimes, SAR plans cap the appreciation to which the employee is entitled.
e) Phantom stock: Under a phantom stock plan, an employee is granted a hypothetical number of units of stock that are convertible into cash or common stock of the company after a period of time. Similar to SARs, the form of phantom stock plans can come with cash-settlement or stock-settlement features. Typically, though, phantom stock plans are structured as cash-settled awards.
2. Know the difference between Stock Compensation (718) and General Compensation (710): To determine which accounting guidance to apply, you need to analyze carefully whether the value of your awards is based, at least in part, on the price of your shares or other equity instruments, or if the awards require settlement by issuing your equity shares or other equity instruments. If the awards meet one of these conditions, they must be accounted for under ASC 718; otherwise, they are likely subject to other guidance, such as ASC 710. The accounting and disclosure requirements in ASC 718 are quite different from those in ASC 710.
3. Profits interest awards: This type of compensation, similar to a cash bonus, has become more popular in recent years, particularly among venture capital-backed or private equity-backed companies. A profits interest award is essentially a right to receive any residual profits after distributions to other equity holders. Significant accounting challenges arise in accounting for profits interests, including whether they ought to be accounted for under ASC 718 or ASC 710. If the awards must be accounted for as SBC under ASC 718, there are additional complexities around the valuations of profits interests and the timing of when their value should be recorded as a cost in the financial statements.
4. Equity-classified awards vs. liability-classified awards: When SBC awards are within the scope of ASC 718, the company needs to determine whether the SBC awards are considered equity-classified or liability-classified awards. Under ASC 718, SBC awards with certain characteristics are classified as liabilities. For example, SBC awards that will be settled in cash or settled in stock that can be redeemed within six months after exercise are considered liability-classified awards. For nonpublic entities, liability-classified awards must be revalued at fair value or intrinsic value every time GAAP-based financial statements are prepared — until the awards are settled or expire. Accounting for equity-classified awards is based on the grant-date fair value. Unlike liability-classified awards, equity-classified awards are not subject to revaluation (unless the awards are subsequently modified), even if the company’s value increases significantly.
5. Vesting considerations: SBC awards typically include one, or a combination of, the following vesting conditions:
- Service conditions (e.g., employment service);
- Performance conditions (e.g., sales/EBITDA target, IPO, or change in control, etc.); or
- Market conditions (e.g., stock price target, multiple on invested capital, internal rate of return thresholds, etc.).
Note: Service conditions or performance conditions are not factored into estimates of fair value or intrinsic value, but market conditions do need to be reflected in the valuation process.
6. Option pricing models: Many SBC awards are structured in the form of options. The fair value of options with service or performance conditions may be measured using a Black Scholes Merton model. SBC awards with market conditions are often measured using more complex methods, such as Monte Carlo or Lattice simulations.
- Black Scholes Merton: The BSM model incorporates certain assumptions and inputs, such as the current value of the underlying share, expected term and expected volatility. For nonpublic entities, ASC 718 provides a number of practical expedients for reducing the cost and complexity of estimating the fair value of option awards. In 2021, FASB issued an update to help private companies determine the current price of underlying shares for equity-classified share-based awards. The amendment under ASU 2021-07 provides nonpublic entities with an option to determine the current price of the underlying share, using a valuation method acceptable under Internal Revenue Code Section 409A that is determined by an independent valuation specialist within the preceding 12 months of the grant date.
- Plain-vanilla: Nonpublic entities are also allowed to determine the expected term of “plain-vanilla” SBC awards, using the simplified method that provides a midpoint between the end of the requisite service period (typically, the vesting period) and the contractual term of the SBC awards.
- Monte Carlo: The Monte Carlo method simulates a wide variety of potential scenarios involving an option award. The value derived from the Monte Carlo simulation represents the probability-weighted average of the pathways where the awards become exercisable and are anticipated to have future intrinsic value.
- Lattice: The Lattice model is a technique that produces an estimated fair value based on the assumed changes in prices of a financial instrument over successive periods of time. A lattice method is used to value options with a discrete time frame, in which a decision to exercise the option is required at all times, or at any time before and including maturity.
Applying a Monte Carlo or lattice model can be challenging since both models require a significant amount of data and judgments, such as grantee exercise data, varying interest rates and anticipated volatilities. I typically advise my private company clients to obtain the assistance of a valuation expert if it is necessary to use these models to value SBC awards.
When private companies procrastinate on SBC accounting
If a company has plenty of time to make its financial information GAAP compliant, then SBC accounting is doable and not that stressful. However, I’ve seen too many startups on the cusp of equity or debt financing, M&A transactions or IPOs forced to work around the clock to become GAAP compliant if they have not kept clean records of each SBC award since their inception. SBC accounting cannot be done without a complete set of SBC grant information, including:
- A stock option ledger containing SBC activity from inception to date, including the number of shares granted, vested, exercised and forfeited;
- Classification between employees and nonemployees and ISO v. NSO;
- Vesting schedules by SBC award;
- A summary of vesting conditions, that is, service conditions, performance conditions and/or market conditions for each grant;
- Periodical equity valuation reports, such as a 409A valuation, to support the value of the underlying shares of equity at each grant date; and
- A list of comparable publicly held companies.
The regulations, timing and calculations can be complex. Companies may want to enlist the help of an outside specialist to guide them through the process so they don’t have costly and embarrassing fixes to make down the road.
