Guidelines for Employee Stock Plans (ASC 718)
In short, it is important to understand the tax obligations that are connected to each plan, such as the ASC 718 rule.
You might have an idea about the benefits of equity compensation or maybe you already participate in your company’s employee stock plans. Just as there are some rules for employees for stock options as in the ISO 100K limit, some rules also apply to employee stock plans that are offered by the company.
In short, it is important to understand the tax obligations that are connected to each plan, such as the ASC 718 rule. For people who are new to understanding the ASC 718 rule or are not aware about the various employee stock plans, this article will give you an understanding on how these apply to you.
What is ASC 718?
ASC here means Accounting Standards Codification. The ASC was developed by the FASB, which is the Financial Accounting Standard Board in 2009. It acts as the authoritative and centralized source of GAAP (generally accepted accounting principles) that is utilized for financial reporting in the US.
The ASC 718 is a part of the law that controls the accurate expensing of stock-based compensation issued to employees on the income statement of the company. Not only for the employees, it is also the standard for expensing equity compensation that is issued to any non-employees of the company offered shares as well.
Note: Just to be clear about ASC 718, it comes after the FAS 123(r), and there are many experts who still refer to the accounting codification in this way.
Let us now understand why the ASC 718 is needed and why is it used. Initially, startup technology businesses used to offer equity instead of cash to leverage the best talent in the industry. After that, equity compensation then began to spread across to other businesses and high-growth industries.
Used to attract, retain and incentivize increasingly talented employees, it became a popular form of employee compensation, where many employees began to expect equity compensation along with their salary. Offering employees with equity as incentives has many advantages:
- Reduced Employee Turnover: With a strategic vesting period, employees are given an incentive only if they stick around for a specific period of time (normally a vesting period with a 1-year cliff). This means that in case an employee leaves the company before the one year period, they lose all the unvested shares. Another motivation to stay with the company is by keeping an eye on the value of the company’s stock. As the value of the company increases, so does the value of the stock and of the awards given to the employees.
- Deeper Incentivization: The employees who work towards the success of the company with owning the company’s shares, tend to be more motivated and work harder to grow the company. This kind of motivation is highly needed and has a lot of power, mostly for private startup companies.
- Conserving Cash: With the help of equity compensation offered to employees, companies have the chance to put their cash into other places that would help the business grow better. This is relevant mostly for startup companies that have a stiff budget or are cash-strapped.
Even though these benefits are available, equity compensation is not very easy. Equity compensation is a highly regulated activity all over the world. And for a company to use it, they need to be smart and have experience. Also, it is important to have advisors who have knowledge related to securities laws, accounting standards, tax regulations and the administration processes.
From the accounting perspective for equity compensation, it can be highly complex to track and even to expense. This is mostly for the companies that have international or mobile employees. That is where the ASC 718 comes in. It spells out all the accounting treatment for equity used for companies in the US.
But if you sit down to do the calculations according to the ASC 718 rule yourself, you may end up pulling out your hair from the complexities of it all. And this is the main reason why you may need an expert who is well-versed with all employee stock plans and the laws that govern them.
Broad Based Employee Stocks
Before we dive deeper into the ASC 718, let us have a little understanding about the various broad-based employee stock plans. “Broad-based” employee stock plans are those where most or even all of the employees can participate in, depending on the limitations the company puts in place. So, here are some possibilities for broad-based employee ownership:
ESPP (Employee Stock Purchase Plan)
One employee stock plans is the ESPP, and is a bit like a stock option plan (explained below). The plan allows employees to purchase stocks from the company, mostly through payroll deductions from a period of 3-months to 27-months, called the offering period. Unlike stock options, this plan has an added benefit, where shares are offered at a discounted price, allowing the employees to benefit even if the share price goes down in the future.
As soon as the employees get the shares, they can then sell it in the market for the FMV of the shares, or they can hold onto the shares, for the FMV to increase. Most of the companies putting up ESPPs are tax-qualified “Section 423” plans. It means that nearly all employees who are working full-time and who have 2 or more years of service would be allowed to take part in the plan. Even though this is offered as such, there are many who choose not to take part.
There are two kinds of stock option plans – incentive stock options and non-qualified stock options. These are one of the employee stock plans that many companies opt to offer to their employees. Under this stock option plan, an employee gets the rights to purchase the company’s share at a determined price within a specified period, after it is granted and vested with the employee.
ESOP (Employee Stock Ownership Plan)
ESOPs are popular employee stock plans as they are a tax-qualified employee benefit plan. In this plan, most or all of the assets are invested in the employer’s shares. With this, the participating employees must be full time and meet specific service and age requirements.
To explain the ideology of ESOPs, employees are not required to purchase the company shares. Rather, the company offers its shares under this employee stock plan. Usually, the shares offered are taken from an owner of the company and added to the plan. Another way how this plan works is that the company can also borrow money to purchase the stock to add into the plan, and later on, the company then has to pay the loan back that was borrowed.
The company has some benefits under the ESOP plan. The benefits are applied for the seller and employers involved in the plan as well. The employees then vest their accounts after they are awarded with the stocks, and receive the benefits of the plan when they leave the corporation, although a lot of companies offer distributions before that.
Other Individual Equity Plans
There are many other individual employee stock plans as well, such as restricted stock, phantom stock, stock appreciation rights (SAR), and stock awards (also called performance shares).
Stock awards are the most direct plans, where the shares are directly granted to employees. Mostly, there are cases where this type of shares are awarded on specific conditions for performance (corporate level, group level or even at the individual level). This is the reason why they are also called performance shares.
Another employee stock plans is SARs, also called stock appreciation rights. It basically offers the rights to the increase in value of the nominated amount of shares, mostly those paid in cash, though they are seldomly settled in shares. This plan is also known as the “stock-settled SAR.”
Next comes restricted shares, which are given to employees to get the rights to purchase shares or get shares as a gift at a discounted value. In this plan, they can only get the possession of the shares of the company, and only after some specific restrictions are met, such as vesting requirements.
Another employee stock plans are phantom stocks, which pays a share bonus or cash that is equal to the value of a specific amount of shares. When the phantom stock awards are used in stock form, they are known as restricted stock units.
Now that we are clear with what the various employee stock plans are, let us understand how the ASC 718 works and what it has to do with these employee stock plans.
How does ASC 718 work?
When a company issues equity through any of the employee stock plans, and if this corporation has all the financials audited, the company would have to expense the compensation as per the ASC 718.
There are many steps that need to be followed for accurately ascertaining and reporting the equity compensation expense as per employee stock plans under the ASC 718. These steps are:
- You would have to have a proper business valuation done utilizing the option pricing model, which is mainly called the Black-Scholes method.
Note: Privately-held companies might require some assistance for calculating the FMV of the shares. For this, it is better to contact an expert knowledged in the Black-Scholes method.
- As soon as you have the value of the business in hand, you would have to figure out the total expense to the corporation over the vesting period.
- In the next step, you would have to decide which method you should utilize in determining the expense.
- At last, you would have to make some disclosures on your financial statements.
Even though these steps seem straightforward and simple as per the ASC 718 for employee stock plans, it is highly advised to take the help of experts so that you do not make mistakes in the process.
How to calculate the ASC 718 expense?
This part would give you an insight as how to interpret the information you get regarding the ASC 718 expense, but it is not a framework on how to calculate it. Moving ahead, there are two steps involved for calculating the ASC 718 expense. Let us use an example to walk you through the steps with the following details:
- Grant Date: January 1, 2019
- Vesting Commencement Date: February 1, 2019
- Expiration Date: February, 2029 (10 years after grant date)
- Vesting Schedule: 4 Years Annually (25% on each yearly anniversary)
- Strike (exercise) Price: $2
- Shares: 40,000
The shares are granted to Mike Wilson, who is a full-time employee of the company. Now let’s dive in:
Step 1 – Valuing the Options
The first step is that the company needs to figure out the value of each option. Even though the 409A valuation (explained in another article here) is the normal way to get the value of the business for offering options, it vital to note that the actual value of the options are not the same as the value that is determined from the 409A valuation.
Basically, the 409A valuation gives a value of the common share. While the 409A valuation is normally utilized for setting the strike price for shares, the shares have separate values that are different from the 409A value. A lot of people mistakenly assume that the value of the options are worthless when the strike price is $1 with the common shares valued at $1 or lower. Well technically, if the corporation was being sold on the day the shares were granted, this would be right.
However, if the shares of the company are truly worthless, employees would not bother to consider even taking options as compensation under any employee stock plans. The value of the shares are based on the future potential on the company’s success. And as per the ASC 718, the Black-Scholes calculation is used to quantify this future value.
Calculating the Fair Value of the Options
To explain it better, the “Fair Value” here was defined by the FASB in 820-10-35-2 as “the price that would be paid to transfer a liability or obtained to sell an asset in an orderly transaction at the measurement date that is between market participants.”
This means that the fair value of the option is not the value of the underlying stock nor the strike price, nor is it the difference between both. Basically, the fair value is the rate for which the share would be bought in the open marketing as per the date of the measurement (when the value is determined, and for the employee it is the grant date).
But since the shares of the private companies are not available in the open market, the fair value has to be calculated. This is done by using methods like the Monte-Carlo Method, Lattice Model, or the Black-Scholes Model. Nonetheless, the Black-Scholes Model is used the most as it is the most straightforward and easiest method to use.
The Black-Scholes Model
The Black-Scholes is a formula that gives the value of derivative securities based on the following 5 criteria (as per the example):
- Strike Price – Here it is $2.
- Underlying Value (the value of common shares) – For this, we would assume it as $2. Private companies issue shares that have the strike price equal to the common stock’s value, which is determined by the 409A valuation.
- Term (or time until expiration) – This part becomes difficult and even though you see it as 10 years, it may not be. The FASB has applied some strict guidelines for it to be shorter. For a public company, we can check the market rates. With an extensive history of exercises, you can use that as basis. But the companies that are private do not have it. Moreover, the FABS had put out a bulletin (SAB 107) that advises a weight between the time to expiration and the vesting schedule. With this, we get the term of 6.25 years. (You would need an expert for calculating yours).
- Volatility – This is a tricky input. Here, the variance of the stock price of the company over time has to be calculated. In short, we need to know how much fluctuation there was in the price over 6.25 year period. Being a private company, this would be tough. And this is why private companies use the sets of public companies to determine the value. (Again, you need an expert at this step). Let us take the volatility as 40% here.
- Risk Free Rate – This is the last input, which is the interest rate at which you can lend money. Here there would be certainty that you would be paid back. As since the US government will not default on its debts, we use the same interest rates. You can get the rate on the US treasury website. Since there is no rate for 6.25 years, we would go with the rates between 5 and 7 years, which is 1.35%.
Now that all the values have been gathered, it can be entered in the Black-Scholes Model and the fair value can be determined. As per the find in this case, Mike has options with the value of $0.818 per share.
Step 2 – Amortizing the Expense
Wouldn’t it be great to just get the option’s value, list the complete amount as the expense in the grant year and have it done? Regrettably, the stock options GAAP accounting needs some other things. The expense has to be spread across its useful life, which is normally defined as the vesting period of the option. In this step for the getting the value of the option from the employee stock plans, the expense is spread out to match the vesting of the option.
Let’s use the example above where Mike finds the value is $0.818 per share. And we know that 25% of the shares usually vest by 1st February every year for the next four years. Here, the expense is $8,180 for each year (10,000 shares * $0.818 per share). But it is not this simple. Here are some other instances of common complexities, and how it is treated.
In case the option is canceled in the middle of the vesting period, then no added expense should be listed later on. But the expense has to be listed for vesting that happens despite of if the vested options are eventually exercised or not. Hence, if Mike vests the options halfway and then decides to leave the corporation and does not exercise the remaining options, the expense would still be booked for the half the amount vested.
On the other hand, in case the exercising of an option is done earlier, the expense would take place as if there was no transaction, as long as the restricted stock keeps being vested. If they are canceled, it would also stop the expense on the option.
Moreover, in case the end of the fiscal year falls in the mid of the cliff period on the grant, the expense would have to be booked for an estimated part of the share in the cliff even if the vesting has not taken place yet. And finally, a forfeiture rate would have to be considered on the unvested shares.
With this, you can find out that the calculations can quickly become confusing. Even though some parts can be straightforward, it becomes highly wearisome when it involves calculating for dozens of options. You would need an expert to help you with it or a tool.
But before we can talk about tool, you would need an updated cap table that would help you track all the shares so that the calculations can be made right. For that, Eqvista is the right app for you. Check it out here.
With all the details regarding how the options needs to be expensed and what the ASC 718 is about, you can now choose one of the employee stock plans from the list and begin to work on granting them to your employees. But as you do so, ensure that you have your cap table ready to keep track of all the shares moving in and out of your company. Find out more about Eqvista here and start using it today!