Startup employees are often issued equity as part of their compensation package from the company. And similar to how employee salaries are a company expense, so too is the value of the equity that is issued to them. ASC 718 reports are used to calculate the compensation expense associated with the company’s equity issuances and is reflected on the company’s income statement. Why the need to calculate equity expense? Because it is considered compensation, it is taxable to the recipient and is deductible by the company as an expense. ASC 718 calculations can be somewhat complex and this blog post provides high-level information to help demystify the process.What calculations go into generating an ASC 718 Report?
There are two primary steps that go into calculating equity expense for the purposes of an ASC 718 Report. First, the fair value per share of the option must be calculated (note that fair value is not the same as the more familiar fair market value, or FMV—more on how fair value is calculated below). Next, the total fair value (fair value per share times number of shares) of the option grant is expensed over the grantee’s requisite service period for the purposes of accurate yearly reporting. The service period usually corresponds to the vesting schedule of the option; for example, an option with a four year vesting period with a one year cliff would have a four year service period.
Fair value is the price at which an option would be sold as of the grant date. However, since most startups are privately held companies, it’s not possible to determine fair value from publicly bought and sold stock. To calculate fair value per share, the Black-Scholes formula is typically used. This formula has 6 variables:
- Fair Market Value (the value of the option at the time it was granted; determined by a 409A valuation)
- Exercise Price (the price paid by grantee for the option when exercised)
- Expected Term (calculated by using the following):
- Tranche Resolution (how often granted options are vested)
- Vesting Length
- Cliff Length
- Option Life (the contract term for the window to exercise options; industry standard is 10 years)
- Interest Rate (constants taken from Federal Reserve Board and then calculated using Contract Term)
- Volatility of Security Price (constants can be computed by a free online third party, or raw stock data from peer companies can be imported from Yahoo Finance and computed in-house)
- Dividend Rate (this should be zero for all privately held companies)
For the Black-Scholes calculation, all these variables have to be determined on a grant-by-grant basis: you have to do the calculation multiple times to get appropriate variables for each option grant. Interested readers can get a lot more into the weeds on understanding the variables in the Black-Scholes formula (for instance, see PwC’s publication on Stock-Based Compensation), but for the purposes of this blog post we’ll leave you with the formula variables.
Once fair value per share has been calculated, total fair value for the option grant can be calculated by multiplying fair value per share by the number of shares granted. Total fair value then has to be amortized over the option’s “service period” (typically the vesting schedule)—you cannot expense the total fair value all at once but rather must expense it on a yearly basis. This is a GAAP (Generally Accepted Accounting Principles) requirement. Of course, this isn’t simply a matter of dividing the total value by the number of years on the vesting schedule. There are additional factors to consider:
- Forfeiture rate: the forfeiture rate accounts for expense “haircuts” due to anticipated employee departures or terminations and accompanying reduction of vested options. Annual forfeiture rate can be based on either company historical data or, if adequate historical data is not available, peer data.
- “Truing up” to account for actual vesting: when reporting options expenses as part of your company’s compensation expenses, you’ll need to correct any differences between expected forfeiture rate and actual termination/departures.
Once an option has fully vested over its lifetime vesting schedule, your company will have expensed the total fair value of the grant.When do I need to generate an ASC 718 Report and who can do it?
Many companies forego ASC 718 calculations until they elect or are required to prepare audited financial statements (often after a venture capital financing). Your accountant can help you determine when an ASC 718 Report may be necessary.
As you’ve likely gathered from reading this post, generating an ASC 718 Report can be a time-consuming and complex process. ASC 718 Report calculations are often outsourced to CPA firms, or companies buy a software solution. Shoobx has a built in ASC 718 tool that will generate a Microsoft Excel file with most of the data needed to file your report, and once the file is generated you and your accountant should review it together before filing.