Stock options and equity grants are an important tool for startups to attract and retain top talent.
If you compare salary dollar figures, potential or current employees might be able to get a more impressive offer from a larger company.
Your startup’s ability to grant stock is a differentiator. Team members have a chance to actually own a piece of the company – which can turn into a lucrative payday in the event of a merger, acquisition or IPO. Especially if colleagues believe in your vision, the potential goldmine of startup equity can be a great motivator.
In order to reap the benefits of stock-based compensation, your startup must take the corresponding accounting measures under generally accepted accounting principles (GAAP). ASC 718 is the accounting standard for share-based payments, and it’s an essential set of rules to understand as your startup is preparing for an audit.
Perhaps you’re readying for your first round of fundraising and due diligence, and you need to wrap your head around ASC 718 reporting. You might even be on your Series A or Series B – but memorizing the rules of GAAP accounting for stock options isn’t a walk in the park. Each ASC 718 report builds on the prior version, so it’s helpful to continue building good habits.
No matter where you’re at in your startup journey, Shoobx’s free webinar, “ASC 718: How to Stay Audit-Ready and Boost Investor Confidence” is a great place to refresh on all things ASC 718. Scott Goodwin, Principal at Wolf & Company – a national CPA and business consulting firm – gives insights on stock-based compensation and some tips and tricks on preparing for an audit.
We’ve compiled the essential points below:
What is ASC 718?: GAAP accounting for stock options
The “ASC” in ASC 718 stands for Accounting Standards Codification.
ASC 718 reporting is how companies must expense share-based payments on their income statement. It specifies the GAAP treatment for the most common form of share-based payment – stock options – but also applies to stock appreciation, restricted stock units and restricted stock grants.
As you know, many startups enhance their job offerings by complementing a salary with an ownership stake. Since equity is considered payment for an employee’s services, it is taxable to the recipient and deductible to the company. Preparing an ASC 718 report helps your startup calculate and document these expenditures for equity grants. In other words, it's a simple way for your company to disclose the cost of its equity grants.
Why is GAAP Accounting for Stock options important?
For a pre-fundraising, early-stage startup, ASC 718 might not be immediately relevant. However, once you begin fundraising, it’s likely you’ll put a stock option pool in place. You’ll then start to consider where employee equity comes from – the founders’ share, or the VC’s?
ASC 718 becomes increasingly relevant as you’re preparing for an audit – likely when you’re approaching a Series A or Series B fundraising round. Investors will want to see an ASC 718 report as part of their financial due diligence – when you must prepare audited financial statements in accordance with GAAP. Lenders, regulators and potential M&A partners would also be interested in this report.
Sometimes, the ASC 718 topic arises sooner, such as when you enter a joint venture or licensing agreement before seeking venture capital financing.
ASC 718, Chapter 409A and Fair Value
So how does ASC 718 relate to other essential startup documents? For one, it’s associated with your 409A valuation, an IRS tax-related item that directly ties to the value of your employees’ stock options.
Both 409A and ASC 718 deal with share-based compensation. 409A is the tax standard for the Internal Revenue Service (IRS), while ASC 718 is the GAAP accounting standard.
A 409A Valuation Report produces what’s known as the fair market value of your stock. This fair market value helps you determine your stock’s fair value (notice we don’t use the word “market”), a separate calculation upon which an ASC 718 report is based. (We discuss the difference between fair market value and fair value in a separate post.)
Scott Goodwin, Principal at Wolf and Company, explains it like this: “Chapter 409A provides the valuation so that you can set the exercise price of your stock option to comply with internal revenue code requirements. The fair market value that comes out of the 409A valuation is going to be an input into the calculation for your stock compensation under ASC 718.”
Fair value is determined by a calculation known as the Black-Scholes model.
What can go wrong when preparing for an audit?
Goodwin says that most companies make mistakes on their ASC 718 report when they attempt to handle the entire process manually. Busy CFOs that try to handle all calculations in spreadsheets – and don’t lean on a hired CPA firm – are at risk of human error.
“Half knowledge is dangerous,” Goodwin said. “Make sure you check in with your financial consultant or CPA to make sure you’re on the right track.”
Another common issue is procrastination. Startups shouldn’t wait until the eve of due diligence to get years of stock-based compensation reporting in order.
“Like most things that you ignore, it just gets worse the farther you go along,” Goodwin said. “If you have three years of granting history and someone has now said you need to produce GAAP financial statements in the next six months, getting that three years of history into any cap table management software is not going to be that simple. It’s going to create additional stress and time.”
But it’s not just stressful for company leadership. Your employees’ compensation is tied to their stock options. If you’re forced to make adjustments, employees will have to do corresponding work to report their income to the IRS.“What’s supposed to be a benefit turns into a tax headache,” Goodwin said.
How equity management software can help with ASC 718
ASC 718 isn’t likely the primary motivator for incorporating equity management software into your tech suite. This software helps with big-picture issues like document execution, storage and cap table inputs.
However, Goodwin notes that automated equity management software – which automatically syncs your cap table with data from relevant documents like equity grants – brings the underrated benefit of easier ASC 718 report generation.
“I can say definitively there are fewer issues that come up when someone is using a cap table management software,” Goodwin said. “It’s nice to be able to have that automated equity management functionality when you do have to start producing GAAP financial statements.”
Shoobx organizes everything you need to create ASC 718 reports, including grant types, vesting schedules and Stock Incentive Plan details. Startup leaders can generate an ASC 718 report with a few clicks. Combine this functionality with a knowledgeable CFO and a trusted CPA firm, and you have a recipe for ASC 718 success.