How does ASC 718 affect the valuation of startups during fundraising?

CB Insights reports that 38% of US seed-funded tech companies fail to secure additional funding, while a staggering 97% are unable to raise capital by their sixth funding round. Hence, in today’s startup landscape, entrepreneurs must strategically utilize every facet of the business to arrive at optimal startup valuations in fundraising rounds.

While product innovation and market potential remain important, astute investors scrutinize minute financial details such as ASC 718 disclosures.

ASC 718 is a seemingly mundane accounting standard that has become quite an effective startup fundraising differentiator. After all, it provides a glimpse of the company’s compensation philosophy, talent retention strategy, and potential dilution risks.

Importance of ASC 718 in Financial Reporting

ASC 718 is the short form used for Accounting Standards Codification Topic 718. It is an accounting principle established by the Financial Accounting Standards Board (FASB). The rule prescribes how stock-based compensation given to employees and other service providers should be accounted for.

We can summarize the core of ASC 718 as follows:

• Valuation – The company must establish the fair market value (FMV) of its stocks with a 409A valuation. This will form the basis for calculating the exercise price, expense to the company, and the employee’s taxable income from stock compensation.
• Allocation – Expenses must be allocated over the vesting schedules through the straight-line method or the FIN28 method.
• Disclosure – In their financial statements, companies must disclose details of the stock compensation they issued. These details include the number of stock options vested, exercised, and expired, the weighted exercise price for the stock options, and total expense.

Investors will be interested in the ASC 718 disclosures made by startups. While there are no ASC 718 reporting requirements for startups seeking funding, investors can gain valuable insights about a company’s human resource needs and policies through the ASC 718 disclosures.

How do investors view ASC 718 disclosures?

ASC 718 disclosures help investors assess the dilution risk from outstanding stock options and the commitment of the company to retain key employees and management personnel.

In addition to a journal entry describing the compensation expense, under ASC 718, companies must disclose detailed information about stock options, including the outstanding options at the beginning and end of the reporting period, and options granted, forfeited, exercised, and expired.

You must also report the number of exercisable and unvested options at the end of the period, along with the weighted average fair value, exercise price, intrinsic value, expected term, and the remaining contractual term of the options.

The fair value, exercise price, and intrinsic value data enable investors to gauge potential future expenses and cash outflows related to option exercises and share buybacks from employees. Additionally, information on unvested and exercisable options helps in evaluating the timing and magnitude of possible share dilution.

Effects of ASC 718 on startup fundraising

In this section, we will look at ValorStone Capital, a private equity firm, looking to invest in climate tech companies. They have received four invitations to invest. All of these companies are equally appealing but ValorStone Capital can invest in only one. They have decided to look at the ASC 718 disclosure to break the ties.

Company 1: EcoVolt Innovations

EcoVolt Innovations is valued at $30 million with 1 million shares and has been in existence since 2019. A review of their ASC 718 disclosures reveals some red flags, which were:

• High stock option issuance – There were 100,000 outstanding stock options at the start of 2023, but 500,000 additional stock options were issued even though the headcount increased by only 30%.
• Low exercise price – The company is offering a weighted average exercise price of $4 for shares whose fair market value (FMV) is $30. This boosts the value of stock options for the employees but also increases the dilution risk in the future.
• Long expiry term – The average expiry term is 7 years, giving employees a prolonged period to exercise the option. As a result, the expiry rate of stock options will be low. So, the dilution risk is more likely to materialize.

Based on these facts, ValorStone Capital was able to conclude that EcoVolt Innovations is overusing stock-based compensation to attract employees. The overly generous stock compensation plan could dilute the value for existing and incoming shareholders.

Company 2: TerraFusion Technologies

TerraFusion Technologies is another company being considered by ValorStone Capital. It has a valuation of $35 million with 1 million shares and has been in existence since 2021.

ValorStone did not find any evidence of over-compensation with TerraFusion. The risk of dilution was 10 times less with TerraFusion Technologies since they had issued only 60,000 stock options by the end of 2023.

However, a closer inspection of TerraFusion Technologies’ ASC 718 disclosures revealed the following red flags:

• Low intrinsic value – The weighted average intrinsic value of all outstanding stock options was just $5 per share, significantly lower than EcoVolt Innovations ($30 – $4 = $26).
• Short expiry term – Stock options at TerraFusion Technologies had a very short average expiry term of 2 years.
• Universal and equal distribution of stock options – Stock options at TerraFusion Technologies were provided universally and equally. This meant that key employees and management personnel got the same stock-based compensation as entry-level employees.

Since these stock options were difficult to exercise and had a low intrinsic value, they did not benefit the employees much.

Based on these facts, ValorStone Capital concluded that TerraFusion Technologies was not doing enough to retain key employees in a research-intensive sector.

Company 3: GreenShift Solutions

GreenShift Solutions, the final company on ValorStone Capital’s list, was valued at $50 million, had 1 million shares, and had been in existence since 2020.

A close inspection of GreenShift Solutions’ ASC 718 disclosures and some inquiries revealed the following details:

• Stock options issued – GreenShift Solutions issued 120,000 stock options in 2023, representing just 12% of the total outstanding shares. This figure was well-aligned with the 20% rise in headcount growth.
• Exercise price – The weighted average exercise price of $30 per share resulted in a weighted intrinsic value of $20 per share. This limited the dilution risk while incentivizing the employees to perform and remain in the company.
• Expiry terms – The weighted average expiry term of 4 years encourages employees to exercise sooner. It also means that dilution analysis is easy since dilution scenarios need not be prepared for a huge number of years.
• Targeted allocation – 70% of the stock options were allocated to senior leadership and key technical employees, with the remaining 30% reserved for other staff. This ensured that critical talent was retained while junior employees were also motivated.

So, if the expected growth in all companies is similar, it would make more sense for ValorStone Capital to invest in GreenShift Solutions.

Eqvista – Precision in Reporting. Compliance with Confidence!

ASC 718 disclosures offer valuable insights into a startup’s compensation strategy and potential dilution risks, playing a crucial role in startup valuation and fundraising. Like in the ValorStone Capital example, investors scrutinize these disclosures to assess a company’s approach to talent retention and equity management.

Key factors include the volume of stock options issued, exercise prices, expiry terms, and allocation strategies.A balanced approach, as seen with GreenShift Solutions, can positively influence investor perception.

Startups should view ASC 718 reporting not just as a compliance requirement, but as a strategic tool to showcase their commitment to sustainable growth and responsible equity management.

At Eqvista, we offer ASC 718 filing services as well as equity advisory services which can help you stay tax-compliant and make the most of your stock-based compensation plan. Contact us to know more!