What is ASC 718?
ASC 718 discusses the proper reporting of stock-based compensation in corporate accounting. It is the Topic No. 718 in the Accounting Standards Codification, thus called ASC 718. Companies consider it as the standard for expensing equity compensation to both their employees and non-employees. Corporations need to follow these standards in the preparation of GAAP-compliant financial reports.
Why Does ASC 718 matter?
Aside from keeping financial reports that are GAAP-compliant, having an ASC 718 report is very crucial during an audit. With the ASC 718, a company can defend its accounting treatment with its stock-based compensation. To be able to do this, one must understand the following three necessary information about equity compensation:
Understanding the legal terms of equity such as vesting, granting, share count, and contractual information is necessary for every company.
Every business needs to understand the valuation of the company stocks or underlying assets depending on their grant dates.
Other Financial Information
Getting other financial information to determine the value of each option grant is vital for every business. This information includes dividends yield, stock price volatility, risk-free rate, and a comparable basket of stock.
Equity compensation is usually used by startup companies, which may lack the needed cash while the business has just started. However, it may also be used by more mature companies to attract and reward highly-qualified employees. Companies should regularly monitor grant activities and give details about all these activities in the ASC 718 report.
Advantages of Stock-Based Compensation
Employee stock options allow corporations to use their available cash to other areas of the business which need it more. It is vital for any private company at its early-stage to have money for its business operations.
More Meaningful Incentive
Employees who hold company stocks do not consider themselves as mere employees but as owners of the business as well. They tend to have a deeper connection with the company, which results in hard work and professional dedication. Thus, stock-based compensation often motivates employees to help the company prosper and succeed.
Minimized Employee Turnover
Employees holding stock options in a company usually stay longer and wait for the vesting period of their stock options. Moreover, if the value of stocks increases, employees tend to be more satisfied and stay on to work in the company.
Any company that issues an employee stock option will need to expense such compensation following the ASC 718 guidelines. Appropriate reporting and disclosure in the financial statements of the equity compensation expense are necessary in times of audit. To be able to do this, a company needs to have the proper valuation of its stocks using an option pricing model. After this, the total expense to the company over the vesting period needs to be established.
Before preparing the financial statements, the company has to decide on what method to use in recognizing such expenses. Remember that the recording of costs in the financial statements is spread over the useful economic life of the stock options. Just like how amortization and depreciation are taken into account, stock options expense is not recorded all at the same time.
Calculating the Value of an Option
Knowing the worth of stock options will determine how much expense should be reflected in the financial statements. Since stock options, unlike cash, are not liquid, their worth needs to be calculated using a valuation model. ASC 718 does not recommend any specific valuation model to be used by companies. However, ASC 718 enumerated the factors necessary for a proper valuation model, listed below.
1. Expected Term
2. Expected Volatility
3. Risk-Free Interest Rate
4. Strike Price
5. Dividend Yield
ASC 718 lays down the criteria for companies to be classified as Non-Public Entities, listed below.
- Has equity securities that trade in a public market either on a stock exchange (domestic or foreign)
- Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market
- Is controlled by an entity covered by the previous criteria
- Has only debt securities trading in an open market (or that has made a filing with a regulatory agency in preparation to trade only debt securities)
- With only publicly traded debt securities
Per ASC 718, when “a nonpublic company files an initial prospectus in preparation to sell equity securities, the company is considered a public company.” If this happens, the company needs to change some of its accounting policies that may not be applicable anymore.
Estimating fair value using option-pricing models
Most of the time, companies may need to use an option-pricing model to estimate the fair value of employee stock options. Companies do this during equity valuation due to the non-availability of observable market prices of employee stock options. Each model has its advantages and disadvantages, depending on the needs and the assumptions made by companies.
Equity Valuation Models
The Black-Scholes-Merton model uses stock options data such as the period of expiration, stock prices, strike price, expected dividends, interest rates, and volatility. This model is considered as one of the best ways to determine fair prices of stock options. It is a simple and easily understood model with the assumption that stock prices follow a lognormal distribution.
Lattice or binomial models, unlike the Black-Scholes, offer several scenarios to stock options behaviors. It gives companies a broader range of assumptions about future patterns on employee stock options. It follows the idea that assumptions change over time, thus providing a more refined fair value estimate.
The Monte Carlo model is used to represent the probability of different outcomes with the intervention of random variables. Also known as the multiple probability simulation, it is named after a Monaco gambling spot, which depends on chances and random results. This technique is generally used by businesses to evaluate the impact of risks and uncertainties in the valuation of stock options.
Designing Equity Compensation Plans
Companies need to consider the things that can affect stock-based compensation to determine the most appropriate plan design. Businesses should weigh the impacts of compensation plan designs to the company and the employees as well. ASC 718 gives six elements to consider when developing or changing compensation plan designs, whether cash or equity.
1. Restricted Stock
2. Performance Conditions
3. Corporate Governance
Incentive Stock Option Plans
While the appeal of stock options for statups and early-stage companies may ebb and flow, there remains a high expectation on the part of your best employees that they will one day share in the success of your company.
Incentive stock option plans remain an important retention and motivational strategy. Also, there is room to get creative with ‘synthetic’ options and bonuses tied to successfully completed projects and key milestones.
Budgeting for Equity
The size of the initial pool of options and equity you will need depends on the executive team you have on hand and those you will need. For example, if among your founders you already have your CEO, COO, CTO and other key executive team members, you may only need a pool of 10-12% of fully diluted shares available to create a suitable equity compensation plan.
However, if you are yet to bring on several members of your executive team, you may need 15-17% or more of fully diluted equity in the equity pool. A founder may be caught off guard because they needed to come up with 5% equity for the CEO they really want, for example.
In addition to the executive team, you will need to think through your organization as it is now and where you want it to go.
A good practice is to map out an entire organizational chart and then do a bottoms up budget for granting equity throughout the entire organization. Budget out at least two years or to the next equity raise.
Equity Incentive Types
The most common forms of equity incentives for the employees of startups are: stock option plans; stock grants; and stock purchase plans.
Stock options are the most common and preferred form of equity-based compensation.
A stock option gives the employee the right to purchase stock of the employer or its parent corporation. Stock options typically are granted to employees subject to vesting requirements which prohibit exercise of the unvested portion of the option prior to completion of the specific employment or service requirements.
Some options may permit immediate exercise but with the stock subject to a repurchase right on the employer’s part that lapses over the vesting period in a manner similar to restricted stock.
An employee will generally receive one of two types of stock options: Incentive Stock Options (ISOs) or Nonqualified Stock Options (NSOs).
Employees are typically granted ISOs, which must be granted subject to a formal stock option plan and are subject to certain restrictions. ISOs have favorable tax treatment for the recipient in most cases. To ensure ISO treatment of option grants by the IRS, the company should follow certain rules to properly grant stock options to its employees including — but not limited to – having a valuation of its common stock performed on at least an annual basis or more often if material changes to the business have occurred.
Improper option issuances may lead to unintended tax liabilities for both the company and the employee.
Rules for ISOs
- Stock Option Plan must be in writing
- Stock Option Plan must be approved by the shareholders of the company within 12 months of the plan’s adoption by the Board of Directors. The plan may also be approved up to 12 months prior to the adoption by the Board.
- Options must be granted within 10 years of the formal approval of the option plan
- Options must expire less than 10 years from issuance (or five years from issuance for any holders of more than 10% of the company’s stock)
- Options must be granted only to employees of the company (not to directors or consultants)
- Options must be exercised within 90 days of termination of employee status or one year following the death or disability of the employee
- The value of the stock to vest in any one year under the option (based on the value of the grant date) shall not exceed $100,000 and
- Options may not be transferable except in the event of death by will or laws of distribution of assets.
Nonqualified Stock Options (NSOs)
NSOs are often issued to non-employees such as consultants who are not eligible to receive ISOs or participate in statutory employee stock purchase plans, and to key employees or directors to whom the company wishes to grant options.
Assuming that the NSO does not have a “readily ascertainable value” at the time of grant (and virtually no NSOs do), there are no tax consequences for the optionee at the time of the grant.
Employees Stock Ownership Plans
ASC 718 defines the Employees Stock Ownership Plan (ESOP) as “a qualified stock bonus plan, or a combination stock bonus and money purchase pension plan… that is designed to invest primarily in employer stock.”
Reasons for establishing the Employees Stock Ownership Plan:
1. To give employees compensation and ownership incentive
2. As a takeover protection
3. For financing opportunities
4. To take a company private
5. For the transition of ownership (from a single owner or group of owners)
6. For tax incentives
Four Types of Employees Stock Ownership Plan:
1. Non-leveraged ESOP
In a non-leveraged ESOP, the employer contributes cash to the ESOP. The money is used by the ESOP to buy the employer’s stock. It can also be that the employer directly contributes its share to the ESOP.
2. Leveraged ESOP
In this type, the ESOP borrows money from a bank or lender to be able to purchase shares from its own company. It then sells these shares to its employees as part of compensation. The loan is repaid using the annual contributions.
3. Convertible preferred stock with a put option
Some companies issue convertible preferred stock instead of common stock to an ESOP for additional flexibility on dividends. An ESOP can buy a convertible preferred stock, which cannot be traded easily in the market. A put option is included in these non-tradable securities, which gives employees the right to require employers to redeem their shares. A fair evaluation formula shall determine the price of the shares to be redeemed.
4. Convertible preferred stock with guaranteed redemption
The employer may redeem a convertible preferred stock with guaranteed redemption at a price equal to the stock’s initial value. The preferred shares include an option for the employee to convert the shares into a fixed number of common shares after a predetermined period. The performance of the common stock determines the value of the convertible preferred stock.