How does ASC 718 apply to share-based payments to non-employees?

Did you know that the median annual equity retainer for board directors at S&P 500 companies increased at a compound annual growth rate (CAGR) of 3% between 2015 and 2022, while the cash retainer grew at a CAGR of 2% over the same period? During this time, the ratio of median equity to cash retainers rose from 1.7 to 1.85.

This trend highlights that non-employees, such as board directors, are increasingly receiving a larger portion of their compensation through share-based payments.

So, if a company wants to stay tax-compliant, it must pay special attention to the ASC 718 accounting guidelines when dealing with share-based payments to non-employees. Especially since share-based payments to non-employees receive a different treatment than share-based payments to employees.

In this article, we will go over the key recommendations of ASC 718, the differences in ASC 718 guidelines for employee and non-employee share-based compensation, and then, we will see an example illustrating the difference.

Key recommendations of ASC 718

Accounting Standards Codification Topic 718 (ASC 718) is a set of accounting principles set by the Financial Accounting Standards Board (FASB) and it deals with share-based payments to employees and other service providers.

Before we see how ASC 718 guidelines are different for employees and non-employees, let us recap the recommended accounting process under ASC 718 which is:

Calculate fair value

The company granting the share-based payment must first establish the fair market value (FMV) of the shares, i.e. the underlying assets, through a 409A valuation and then use an appropriate option pricing model to derive the value of the stock options.

Allocation of expenses

The expenses can be allocated over the vesting schedule based on the straight-line method or the FIN28 method.

Disclosures

Companies must make a journal entry where the compensation expense for the year is debited and additional paid-in capital is credited. Additionally, in the financial statements, companies must disclose details like the weighted average exercise price, number of stock options issued, unvested stock options, expired stock options, and vested stock options.

How does ASC 718 treat non-employees differently than employees?

After the Accounting Standards Update of June 2018, much of the accounting processes for share-based payments to employees and non-employees were aligned with each other. However, some key differences still remain. Companies must recognize share-based payments to non-employees as if they had paid cash instead of issuing a share-based award.

If a company must recognize share-based payments to non-employees as cash payments, they must report the current value and not the value on the grant date. This also means that key inputs like volatility must be calculated on the current date and not on the grant date.

Let us see what this means through an example.

Example

2 years ago, Finnova Ventures issued stock-based compensation to 5 employees and 5 non-employees. At that time, the FMV of Finnova Ventures’ shares was $10 which has increased to $15. The details of their stock option plan are as follows:

First, Finnova Ventures must calculate the share options vested and to be expensed. Then, it must find the value of said share options. Based on this, the total expense to Finnova Ventures must be calculated. Then, it must make the necessary journal entries and disclosures.

Step 1: How many stock options should you allocate to the current period?

As mentioned earlier, Finnova Ventures can use either the straight-line method or the FIN28 method to calculate the number of stock options vested and to be allocated to the current period.

For the sake of simplicity, we will follow the straight-line method in this example. If you want to see what the FIN28 method looks like, take a look at this article.

The straight-line method involves allocating the stock options equally over the vesting period. So, the stock options vested in a particular period are equal to the total stock options divided by the vesting period.

Let us see what this looks like in our example.

Step 2: How should you value share options?

This is where the treatment of share-based payments to employees and non-employees diverges. We will apply the Black-Scholes model for calculating the value of the options. For employees, we will take the original FMV as an input while for non-employees, we will take the new FMV as an input. We will need to make a fresh volatility calculation for non-employees.

In the Black-Scholes model, call option price = S × N(d1) – K × e-rt × N (d2)

Where,
S = Underlying asset value ($10 for employees and $15 for non-employees)
K = Strike price
r = Risk-free interest rate
t = Time to maturity = Vesting period (-) years passed
N = Normal distribution
σ = Volatility
d1 = ln(S/K) + (r+σ2/2) × t / σ × √t
d2 = d1 – σ × √t

We will take the current benchmark US interest rate, which is 5%, as the risk-free interest.

At the time of option grant, the 3-year volatility of 5 companies similar to Finnova Ventures was considered to calculate the volatility for the option pricing model. The details of the original volatility calculation are as follows:

This average volatility will be used for calculating the value of stock options granted to employees.

Now, let us use the current values for calculating the volatility to be used as an input to calculate the value of stock options granted.

Now, we can apply the Black-Scholes formula to the options data for employees and non-employees to find the fair value of stock options and their expenses.

Step 3: What is the total expense to the company?

To calculate the total expense to the company, we must multiply the fair value with the appropriate options vested and then, take the total.

Step 4: How to make the journal entry and the disclosures?

The journal entry should debit the compensation expense of $749,265.07 and credit the additional paid-in capital. It would look like this:

Finally, the disclosures will look like this:

If you want a more detailed explanation of the ASC 718 disclosures, take a look at this article.

Eqvista- Precision in ASC 718, Expertise in 409A Valuations!

Getting a 409A valuation and following ASC 718 is crucial for tax compliance if you issue stock-based compensations. You must note that ASC 718 requires you to treat stock-based compensations to non-employees as cash payments. So, you must calculate the fair market value (FMV) of the stock and the stock options in each period for non-employees.

Once you understand the process, formulas, and differences in the treatment of non-employees and employees under ASC 718, financial reporting for stock-based compensation can be simple.

At Eqvista, we provide 409A valuations for startups from all sectors and stages and also provide ASC 718 filing services. Thus, we provide comprehensive solutions for tax compliance when it comes to stock-based compensations. Reach out to our team to know more!