how-to-expense-stock-options

So you’ve issued stock options and now it’s time to record the expense. If this is your first time dealing with “ASC 718,” you are likely a bit confused by all the jargon. I want to help fix that!

By the time you get to the end of this article, my goal is to have you conversationally competent around stock option expensing. Perhaps I can best illustrate my goal for you with a short story:

An old boilermaker was hired to fix a huge steamship boiler system that was not working well.

After listening to the engineer’s description of the problems and asking a few questions, he went to the boiler room. He looked at the maze of twisting pipes, listened to the thump of the boiler and the hiss of the escaping steam for a few minutes, and felt some pipes with his hands. Then he hummed softly to himself, reached into his overalls and took out a small hammer, and tapped a bright red valve one time.

Immediately, the entire system began working perfectly, and the boilermaker went home.

When the steamship owner received a bill for one thousand dollars, he became outraged and complained that the boilermaker had only been in the engine room for fifteen minutes and requested an itemized bill.

So the boilermaker sent him a bill that reads as follows:

For tapping the valve: $.50

For knowing where to tap: $999.50

TOTAL: $1,000.00”

My goal is not to turn you into the “old boilermaker” who knows exactly where to tap to fix the problem (and makes it look easy). But I’d like to turn you into the engineer, who is able to effectively communicate with the boilermaker concerning all the particulars, so that the boilermaker can go in and get the job done quickly.

Bonus PDF: Click here to download a PDF version of this report “How to Expense Stock Options Under ASC 718” or check out Capshare’s stock option expense software here.

This means that I’ll use a fairly simplistic example and stay clear of a multitude of edge cases. Additionally, in certain situations there are multiple methods that are acceptable under GAAP, and in these cases, only one method will be demonstrated (but I will try to call these out so that you may then learn about the other methods on your own).

A General Overview of Expensing an Option

The process of expensing a stock option can be broken into two distinct steps:

  1. Calculating the Fair Value of the option
  2. Allocating the expense over the option’s useful economic life

2 steps to expensing stock options

Let’s walk through an example of these two steps using an option grant with the following details:

  • Grant Date: July 1, 2015
  • Vesting Commencement Date: July 1, 2015
  • Expiration Date: July 1, 2025 (10 years after grant date)
  • Vesting Schedule: 4 Years Annually (25% on each yearly anniversary)
  • Strike (exercise) Price: $2.00
  • Shares: 40,000
  • Granted to Naomi Smith, who is a full-time Employee

Step 1: Calculating the Fair Value of an Option

“Fair Value” has a very technical definition and is defined by FASB in 820-10-35-2 as “..the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

So the Fair Value is neither the strike price, nor is it the value of the underlying stock, nor is it the difference between the two (that would be the intrinsic value). No, the fair value is the price at which the option would be purchased in an open market as of the measurement date (for an option granted to an employee, the measurement date is the grant date).

fair market value

Herein lies the difficulty for all private companies: they don’t have options that are bought and sold on a public market (even many public companies don’t).

So the option’s Fair Value must be calculated. There are a couple of methods that can be used, such as a Black-Schole Model, a Lattice Model, or Monte-Carlo Method. But the Black-Scholes is the easiest and most straightforward method, and therefore, the most commonly used.

The Black-Scholes Model

Essentially, the Black-Scholes method is a formula with five inputs. You enter in those five inputs into the formula, and it returns an estimated fair value for the option.

Those 5 inputs are:

  • Strike Price
  • Price of the Underlying Security (common stock)
  • Term (time to expiration)
  • Variance (volatility) of the price of the Underlying Security
  • Annualized Risk-Free Rate

black scholes model formula

So let’s figure out what those five inputs are in our case. All the inputs are going to be as of the “measurement date,” July 1, 2015.

Strike Price

Well, the strike price is easy. We know that it’s $2.00.

Price of Underlying Security

For the price of the underlying security, we will assume that it’s $2.00. Most private companies issue options with a strike price equal to the value of common stock as determined by an independent 409A valuation. If we were a public company – it’d be even easier as we’d just check the market’s closing price for our stock.

Term

Now here is where things get difficult. What do we enter for the term? Often, you will see 10 years entered. But FASB has put out some guidelines that it should be shorter, as most employees don’t wait 10 years to exercise their options. If you have an extensive history of exercises, you can use that as the basis, but most private companies don’t have an extensive history. FASB put out a bulletin (SAB 107) that recommends a weighting between the vesting schedule and the time to expiration. Click here to to learn more about this method. Using it, we get a term of 6.25 years.

Variance / Volatility

Another tricky input is Volatility. We need to calculate the variance of the company’s stock price over time. Simply put, we need to know how much the company’s stock price has fluctuated (by percentage) over the past 6.25 years. If we are a public company, this is as straightforward as looking up our trading history on finance.yahoo.com, but as a private company, we are in a bit of a pickle. This is why it’s common for private companies to use public company comparable sets. If our company is similar to Company A that has had a volatility of 30% over the past 6.25 years and to Company B with a volatility of 50%, then we split the difference and use a volatility of 40%.

Risk-Free Rate

The last input needed is the Risk-Free Rate. This is the interest rate at which you can lend money at with an almost perfect certainty of being repaid. Because the United States Government has never defaulted on its debt, it is a standard industry practice to use the interest rates on US Treasury Bonds as a proxy for the risk-free rate. These rates are updated daily on the US Treasury website. We won’t find a rate for 6.25 years, but we can use a weighting of the interest rates from the 5 and 7 year bonds. Let’s say the risk-free rate is 1.35%.

We now have all five inputs to enter into the Black-Scholes Model. Whatever is the result of that equation will be our “Fair Value.” You can find Black-Scholes calculators online – here’s one that is fairly simple to use. Utilizing the Black-Scholes Model, we find that Naomi Smith’s option grant has a Fair Value of $0.818 per share.

Step 2: Allocating the expense over the option’s useful economic life

Now that we know the value per share, we are ready to record the expense. Naomi Smith has an option for 40,000 shares and at $0.818 per share, that’s a total expense of $32,720, however, this expense is not recorded all at once. The expense is recorded over the useful economic life of the grant.

What is the useful economic life of an option grant? Well, it’s the period of time during which it is incentivizing & compensating the optionholder. Naomi’s grant has a 4-year vesting plan, so this plan is the useful economic life of the grant. After 4 years, she is able to exercise all of her options as they are fully earned.

The most common way to allocate the expense over the 4 year is in even increments – this is called the Straight-Line Allocation Method – but an accelerated method (somewhat analogous to double declining appreciation) can be used.

Let’s use the straight-line method to calculate the stock comp expense for Naomi’s grant for the year 2015. Naomi’s option was granted and begins vesting on July 1st, 2015. At year end, the grant is 6 months or 12.5% through its useful economic life of 4 years. 12.5% of the total expense of $32,720, is $4,090. That’s our expense!

Using this straight-line method, it is easy to see how much expense will be recorded at the end of each year:

Date Percentage of Grant Expense
12/31/2015 12.5% $4,090
12/31/2016 25% $8,180
12/31/2017 25% $8,180
12/31/2018 25% $8,180
7/1/2019 12.5% $4,090

Where it Gets Complicated: Termination of Employment and the Handling of Unvested Shares

Sadly, things are not quite as simple as what’s described above. Naomi’s shares vest in 4 annual installments starting on July 1, 2016. In a sense, as of 2015 year-end, she actually hasn’t earned anything! If she quits her job on December 31, 2015, she does not have 12.5% of her option grant, she has 0%.

This begs the question of whether we should even record an expense in 2015 or if we should just wait until the options have vested? The answer is that we should still record the expense in 2015, but the expense is not final until the options have vested.

In the case where Naomi’s employment is terminated before the shares vest but after December 31, 2015, the expense recorded in 2015 will be backed out in 2016. If Naomi quits before July 1, 2016, the 2015 financials will show an expense of $4,090 and the 2016 financials will show an expense of ($4,090).

Once the options vest, however, the expense is final and is never backed out. Even if Naomi were to quit without exercising, and her options were forfeited, the expense for all vested options remains. The logic is that vested options are “earned,” and the employee has been compensated because they have the right to exercise. Whether the employee chooses to exercise or not doesn’t change whether or not the options were earned.

Forfeiture Rates

It’s a fairly common occurrence that employees will leave and the stock comp expense is backed out. Because of this, GAAP allows companies to (and used to mandate that they) apply an assumed forfeiture rate to any expense associated with unvested shares that are being expensed.

Let’s say that historically, at our company, 10% of unvested options are forfeited each year. Using that as our assumed forfeiture rate, we could reduce Naomi’s expense for 2015 by 10% to $3,681.

However, as soon as her first tranche of vesting occurs on July 1, 2015, any expense that wasn’t recorded because of the forfeiture rate must now be recorded. So the $409 ($4,090 – $3,3681) that we didn’t record in 2015 due to our use of a forfeiture rate will be recorded in 2016. It’s a small “catch-up.”

Please note that whether or not forfeiture rates are utilized, the total expense recognized for a particular grant is always the same. Whether the employee fully vests or terminates employment and only vests partway, the total expense recognized will be the same. The only thing that changes is when the expense is recognized. Using a forfeiture rate is going to push a percentage of the expense off into future reporting periods.

So what’s the point of using forfeiture rates then? Ideally, it creates a more “smooth” expense over time. When an employee leaves, there won’t be quite as much expense to back out in the case where a forfeiture rate was used. And the expense that is backed out will hopefully be offset in that same period by all the “catch-ups” from other employee option grants that did vest. It’s the “law of large numbers” at work.

But the problem with the law of large numbers is that it really only works when you have large numbers. And most private companies don’t have a large numbers of options grants. For most companies, using forfeiture rates doesn’t really help create a more “smooth” expense over time. And this is one reason that FASB no longer requires the use of forfeiture rates – it’s a lot of complicated work that doesn’t always yield great results.

Yes, the whole industry let out a collective sigh in March of 2016 when FASB released ASU 2016-09, allowing for a company to “make an entity-wide accounting policy election to either estimate the number of awards that are expected to vest (current GAAP) or account for forfeitures when they occur.”

Working with a Third-party to Determine Your Stock Comp Expense

Hopefully you now understand more about ASC 718 than when you started reading. You probably aren’t the “old boilermaker” quite yet, but if you made it this far, then you at least deserve the designation of “engineer.”

Calculating your ASC 718 stock comp expense yourself is do-able, but you can also appreciate why many companies choose to utilize software such as Capshare and work with our knowledgeable team. This post tried to use the most straightforward example of calculating an option’s expense but it was still pretty complicated. And there are many edge cases where the option expense must be handled in a manner different from what is described above.

many-edge-cases

Now going back to the story of the boilermaker, there is a small nuance to the story that is easy to miss, but I feel is rather important. The boilermaker’s job was made easier by the engineer’s ability to effectively communicate many of the particulars of the problem. The “old boilermaker” was able to walk into the problem with some of the facts already known, and therefore, solve the problem more quickly.

Likewise, if you enlist an outside expert to help you calculate your ASC 718 stock comp expense, there are things you can communicate to make their job easier. And the easier their job is, the faster it will be completed and the sooner you can move onto your next project. You are only helping yourself!

Things to Communicate to a Third-party When Outsourcing Your Stock Comp Expense Work

The following checklist identifies things you should communicate to whoever is assisting you with your ASC 718 needs. If any of these things apply to you, they need to be communicated clearly and early on in the process; this will help ensure that edge cases are handled correctly the first time around, reducing the turnaround time on the finished project.

 

  1. Have you ever had any “option modifications”? Examples include:
    1. A “repricing” event, where strike prices for existing options were adjusted,
    2. Vesting schedules that were changed
    3. An employee was terminated, but allowed to continue to vest
    4. An “early-exercise” provision was added to existing options, or
    5. Any other changes made to existing option agreements.
  2. Have you made any significant changes to the Equity Incentive Plan Documents that might affect existing options? (Increasing the option pool would not count as a significant change).
  3. Do you have options that were granted to “non-employees” (in general, if they don’t have a W-2, then they are not an employee)?
  4. Do you have any options with milestone provisions?
  5. Have you obtained an independent 409A valuation to determine the “fair value” of your company’s common stock at least every 12 months (starting with the date upon which your company first began issuing options)?
  6. Have you issued options with a strike price above or below the “fair value” of common stock?
  7. Do you have any previous stock option expense reports or is this your first time calculating expense for ASC 718 purposes?
  8. Do you regularly issue dividends for your common stock?

Bonus PDF: Click here to download a PDF version of this report “How to Expense Stock Options Under ASC 718”

To learn more about how Capshare can handle your ASC 718 reports in minutes, rather than weeks, click “Learn More” below: