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TLDR
- Since the offer and acceptance of equity is typically compensating individuals for their services to the startup, it should be no surprise that equity is taxable to the recipients and deductible for the startup.
- ASC 718 is the “standard way companies expense employee stock-based compensation on an income statement.” When expensing employee stock-based compensation, founders should calculate the fair market value (FMV) of the stock option, allocate the expense over the stock option’s “useful economic life,” and then record the compensation expenses on the startup’s income statement.
- Many early stage startups may not document employee stock options. However, as startups grow and embark on larger funding rounds, startups typically become GAAP compliant. GAAP stands for “generally accepted accounting principles” and represents the “standards that encompass the details, complexities, and legalities of business and corporate accounting.”
- As your startup moves forward into bigger funding rounds, such as Series A, B, or C, you’ll more than likely need to incorporate ASC 718 into your financial practices. Before investing, larger investors will want assurances as to your startup’s financials. This reporting is not to be ignored. But knowing it’s coming – hopefully sooner rather than later based on your startup’s growth – can help you prepare ahead of time, so you don’t leave big investors with questions.
- Because stock options are typically illiquid assets (meaning they are not yet exercised), founders can’t determine the value on the open market. Recognizing this, ASC 718 lists factors that should be considered when determining the options’ FMV.
- “Economic life” refers to “the length of time an asset is expected to be useful to the owner. It is also called useful life or depreciable life. The measure of an asset’s usefulness is how profitable it is to keep – in other words, how long an asset generates more income than it costs to maintain and operate.”
- Once the useful economic life is determined, founders can record these expenses in one of two ways: (1) recording the expenses as a single expenses on a straight-line basis, or (2) recording the expenses in increments, meaning that they treat the satisfaction of each vesting period as a separate stock option award (and associated expense).
One of the many perks of a startup is the ability to earn equity in the company – for founders, employees, advisors, investors, and more. Offering equity can attract capital but also attract and retain top talent, something startups need in a competitive market.
Since the offer and acceptance of equity is typically compensating individuals for their services to the startup, it should be no surprise that equity is taxable to the recipients and deductible for the startup.
Enter the ASC 718. An ASC 718 report helps startup founders to calculate and document any grants of equity, enabling startups to disclose equity grants’ costs. Keep reading to learn more about what ASC 718 reporting is, when it’s needed, and how to prepare the report.
What Is ASC 718?
Before we dig in, what is ASC 718? Formally, ASC 718 stands for Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 718, Stock Compensation (formerly FASB Statement 12R). That’s definitely a mouthful. But, what is the purpose of ASC 718?
Let’s first look at the origination of ASC 718, which Silicon Valley made prominent. Because employees were receiving equity as part of their compensation, many felt that companies should report these awards or else risk inflating profits. As such, the need for standardized reporting of equity-based compensation became a national conversation.
ASC 718 is the “standard way companies expense employee stock-based compensation on an income statement.” When expensing employee stock-based compensation, founders should calculate the fair market value (FMV) of the stock option, allocate the expense over the stock option’s “useful economic life,” and then record the compensation expenses on the startup’s income statement.
The FMV is calculated at grant for the stock-based compensation and then again at the settlement of exercise of the stock award.
For purposes of the above, “economic life” refers to “the length of time an asset is expected to be useful to the owner. It is also called useful life or depreciable life. The measure of an asset’s usefulness is how profitable it is to keep – in other words, how long an asset generates more income than it costs to maintain and operate.”
We’ll explore all of this later in this article.
When Should Founders Expense Employee Options?
Many early stage startups may not document employee stock options. However, as startups grow and embark on larger funding rounds, startups typically become GAAP compliant. GAAP stands for “generally accepted accounting principles” and represents the “standards that encompass the details, complexities, and legalities of business and corporate accounting.” And here’s the tie-in to ASC 718. According to Accounting.com, “the Financial Accounting Standards Board (FASB) uses GAAP as the foundation for its comprehensive set of approved accounting methods and practices.”
So, as your startup moves forward into bigger funding rounds, such as Series A, B, or C, you’ll more than likely need to incorporate ASC 718 into your financial practices. Before investing, larger investors will want assurances as to your startup’s financials. This reporting is not to be ignored. But knowing it’s coming – hopefully sooner rather than later based on your startup’s growth – can help you prepare ahead of time, so you don’t leave big investors with questions.
How Should Founders Expense Employee Options?
Now that we know when ASC 718 reporting should be on your to-do list, let’s explore how founders should expense employee options.
Calculating the Fair Market Value of the Options
First, when expensing employee options, founders must calculate the FMV of the option’s value. As we’re operating under standard accounting procedures, founders must calculate the FMV of the option within these guidelines and standard operating procedures.
The FMV represents the monetary worth of the stock option grant, allowing founders to record these amounts on the startup’s income statements. However, because stock options are typically illiquid assets (meaning they are not yet exercised), founders can’t determine the value on the open market. Recognizing this, ASC 718 lists factors that should be considered when determining the options’ FMV.
These include the expected term of the option, the volatility of the options, the strike price, the going interest rate, any dividend yield, and the FMV of the startup according to a 409A valuation.
Allocating the Options’ Expense Over Its Useful Economic Life
Next, founders must allocate the options’ expense over the useful economic life of those options. In other words, now that founders have calculated the FMV of the stock options, it’s time to record their value on the startup’s books.
As we stated above, “economic life” refers to “the length of time an asset is expected to be useful to the owner. It is also called useful life or depreciable life. The measure of an asset’s usefulness is how profitable it is to keep – in other words, how long an asset generates more income than it costs to maintain and operate.”
One way to think about “economic life” is to take into account depreciation and amortization of the options and capture these adjustments on the startup's financial statements. The options’ expenses aren’t recorded all at once; instead, the expenses are recorded over the useful economic life of the assets.
Let’s look at an example of useful economic life. Often, when founders grant stock options to employees, the options are tied to a vesting period, encouraging the employees to stay with the startup for a number of years. Suppose that a startup issues stock options to employees as part of their compensation package. The options are tied to a three year vesting schedule. For purposes of ASC 718, the useful economic life of those options is three years.
Once the useful economic life is determined, founders can record these expenses in one of two ways: (1) recording the expenses as a single expenses on a straight-line basis, or (2) recording the expenses in increments, meaning that they treat the satisfaction of each vesting period as a separate stock option award (and associated expense).
For non-public startups, accounting rules offer special provisions making the compliance with ASC 718 easier.
How Should Founders Prepare an ASC 718 Report?
Now that we understand how founders should expense employee options, let’s review how to prepare an ASC 718 report. Most companies create and report financial statements to boards of directors and investors.
However, young startups – such as those in the pre-seed or seed stage – may not regularly report the company’s financials, especially if they’re not generating much revenue, if any. However, once startups get over the initial funding humps and start attracting institutional investments, the startup must provide standard financial statements monthly, quarterly, or annually.
These financial statements provide necessary insight into the health of the startup, allowing investors to feel confident in their investment or realizing that they may need to step in to right the ship. ASC 718 reporting is part of the overall financial reporting of the startup, helping to give an accurate financial picture. Once startups enter Series A rounds, more than likely they’ll need to start producing ASC 718 reports.
Here are some necessary components of ASC 718 reporting:
- FMV of the options
- Explain and report the options’ expenses over their useful economic life
- Disclose a detailed list of all information you considered, including the methodology of your calculations as well as how you’ll evaluate any future expenses.
In other words, you want to explain your results in the ASC 718 report, not just the conclusions.
Recent Updates on ASC 718 to Understand
Just like most business compliance, founders need to stay on top of updates – or hire a qualified accountant or financial advisor to do so. For example, ASU 2018-70 (which was added in December of 2018) expanded ASC 718 reporting to “share-based payments” to non-employees “in exchange for goods or services used or consumed in an entity’s own operations,” according to EY.
Then, in November 2019, ASU 2019-08 was added by the FASB, applying to “share-based compensation” for customers. In this case, founders must “measure and classify share-based payment awards (both equity and liability classified) that are granted to a customer in a revenue arrangement and are not in exchange for a distinct good or service in accordance with ASC 718.”
Clearly, to make sure your reporting is accurate, you need to stay on top of additions and revisions to the rules. In most cases, startup founders rely on qualified experts to help them in these areas.
We can help!
At AbstractOps, we help early-stage founders streamline and automate regulatory and legal ops, HR, and finance so you can focus on what matters most—your business. If you want to learn more about your ASC 718 reporting requirements, we can help you draft the appropriate documents for your startup. Additionally, we can get your documentation ready, overall shepherding this process to ensure it's done right. Get in touch to learn more!
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