When Should Your Startup Worry About ASC 718?

Heads up: If you’re a new company and you’re having service providers purchase stock, or you’re doing stock grants, then ASC 718 probably doesn’t apply to you. If you’re issuing options to purchase stock, or if you have a 409A valuation, read on!

By compensating employees with stock options, you can hire high quality talent during the early stages of your startup—even when cash is scarce.

You must report this compensation on your income statements, in order to stay in compliance with Accounting Standards Codification Topic 718 (ASC 718). During the due diligence process, investors will audit your company to see if you’re in compliance; if you’re not, it could delay or derail your funding round.

Here’s the right way to report stock option compensation on your company’s income statements, so you can be sure you’re in compliance with ASC 718.

The Financial Accounting Standards Board (FASB) sets the standard for Generally Accepted Accounting Principles (GAAP). All auditing is done according to GAAP, and companies must comply with Accounting Standards Codification Topic 718 (ASC 718) (formerly known as FASB Statement 123R) to stay in compliance with GAAP.

Keep in mind that ASC 718 only governs employee stock based compensation. Non-employee stock based compensation, such as that given to independent contractors or advisors, is governed by ASC 505-50.

As soon as you start compensating employees with stock options—even if you’re a long way from your first equity financing round—you should comply with ASC 718.

Reporting stock option compensation on your income statements from the very start will guarantee you have a history of compliant reporting—meaning, no hiccups when the time for due diligence finally rolls around.

ASC 718 provides guidelines for how companies should expense employee equity compensation. Companies must follow three steps in order to comply:

1. Calculate the fair value of the option
2. Allocate that value as an expense over the option’s useful economic life
3. Report the expense on your income statement

Your company’s stock options do not have the same fair market value (FMV) as the stocks being purchased through them. And they aren’t being traded on a secondary market. So how do you attach a value to options?

There are multiple options pricing models you can use to determine the fair market value of an option. The Black-Scholes model is one of the most frequently. Other models, such as the binomial model and trinomial model, are also common.

An option’s price is usually determined by its intrinsic value and time value. Intrinsic value measures an option's profitability based on the strike price versus the stock's price on the market. Time value is based on the asset's expected volatility, and time remaining until the option's expiration.

The SEC does not care how your company’s valuation is calculated so long as the method is:

1. Consistent with the fair value measurement objective
2. Rooted in established principles of financial economic theory
3. Reflects all substantive characteristics of the award

Also, ASC 718 lists the following factors to take into account, regardless of how you calculate fair market value:

1. Expected term
2. Volatility
3. Strike price
4. Interest rate
5. Dividend yield
6. The stock’s FMV based on a 409a valuation

Not all of those criteria are likely to apply to your company’s stock (for instance, you probably don’t have a dividend yield.) Others—such as a 409a valuation, may or may not be in your plans for the near future—could.

To determine the fair value of your options, consult with your CPA or CFO. Your lawyer may also want to be a part of the discussion. Whatever your options’ FMV, make sure it’s vetted by experienced professionals before you use it to prepare income statements.

Depreciation of large expenses is calculated by taking into account the item’s useful life. Similarly, to report equity compensation as an expense, you must depreciate the value of the option over its useful life. An option’s useful life is determined by its vesting schedule.

In other words, if an option has a four year vesting schedule, the useful life of that option is four years from its grant date.

There are multiple ways to report options as expenses over time. Some of the most popular:

1. The straight line method, with which the company records the option as a single expense divided equally among the years of the service period
2. The FIN 28 method, which treats each vesting event as a separate award over the set time period

The straight line method may seem simple. But it can be complicated by changes to stock options, ie. in the event of vesting acceleration. This means companies may choose FIN 28 over the straight line method because in practice it is actually easier to use.

Here is an example of how each method plays out. For starters, assume the option has a four year vesting schedule.

1. Using the straight line method of expense reporting, and assuming no vesting acceleration, you would report 25% of the option’s total value each year.
2. Using the FIN 28 method, the shares being vested in the first year are reported as an expense that year; the shares being vested in the second year are reported the next year, and so on. The FMV of the shares is reported as an expense—in effect, the FMV of the values and the options are identical.

For an in-depth walkthrough of stock option expense reporting, see A Technical Roadmap to Expense Allocation Under FAS 123(R).

Stock based compensation (SBC) is recognized as a non-cash expense on your income statement. SBC operating expenses, just like wages, are allocated to their relevant line items.

For example, SBC issued to direct labor—that is, labor involved in direct production rather than administrative and other support operations—is allocated to Cost of Goods Sold (COGS), while SBC issued to R&D engineers can be included with R&D Expenses.

In order to pass due diligence with investors during a Series A or later, you need to be in compliance with ASC 718

To comply with ASC 718 means reporting employee stock option compensation on your income statements

The value of stock options can be calculated using a variety of methods, including Black-Scholes and the binomial and trinomial methods

On your income statement, the value of employee options is depreciated over the course of the options’ useful lives, ie. their vesting schedule

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Just getting started on your journey? Learn the ins and outs of giving equity to your employees.