As your company grows and brings on financing from institutional investors or banks. Institutional investors will have limited partners who require the firms to invest in companies with audited financials. Banks also extend substantial financing under the condition that your company maintains GAAP-compliant financials. At some point, you will therefore need to prepare GAAP-compliant financials, and you will quickly find that you have to comply with Accounting Standards Codification topic 718, or ASC 718, which describes how to report stock-based compensation in your corporate accounting.
Before we talk about ASC 718, let’s take a quick 30,000-foot view of accounting.
Accounting 101, GAAP, and Equity
Under GAAP (generally accepted accounting principles), which is a standard defined by the non-profit Financial Accounting Standards Board (FASB), all of a company’s economic activities, like profits, purchases, debts, and value created for shareholders, must be recorded in specific ways and attributed to the period of time during which they are generated. It’s a system that depends on the consistency and judgment of a practicing, experienced accountant who knows the business and the industry.
Accounting for the normal in-and-out flow of capital is fairly easy to understand, with a little research, but there’s one major category of value that’s a little harder to grok: equity. Startups and venture-backed businesses usually grant equity to team members and key advisors, and the value of that equity is derived from the business’s overall value (which is why companies need 409A reports to peg the fair-market value of shares). But in accounting terms, it’s also an expense—just like employees’ salaries, equity compensation is the value that flows from the company to other parties over time, and as such needs to be recorded on the company’s books to comply with GAAP.
Putting a dollar amount and attributing a time period to this type of compensation can be significantly more complicated than many other common accounting activities, but since it’s a GAAP requirement, it’s important to record the expense correctly. Helpfully, FASB describes the standard in its Accounting Standards Codification (ASC) in section 718—so the activity of recording stock-based compensation is typically called an ASC 718 report.
What is ASC 718?
One of the more complicated areas to keep reporting on is non-cash compensation expenses. This is complicated because, well, it’s not cash, which makes it a bit abstract in nature.
We’re talking about stock options: what you, your executive teams, and employees are placing bets on. If your last round of financing was $2 / share and you gave your engineers 10,000 shares that vest over 4 years, what do you present on your financials? ASC 718 sets out some guidelines so that you can report on:
- The granting activity that your company has been engaged in each year.
- The value that this activity represents (in dollars and shares), and finally,
- The assumptions made to convert the shared activity to dollar figures
Why do you need an ASC 718 report, and how does it work?
Aside from complying with GAAP, defending the accounting treatment of your company’s stock-based compensation with an independent ASC 718 report is critical when it’s time to deal with audits.
To justify the accounting treatment of your equity grants, you’ll need to know a few key pieces of information:
- Legal terms of the grant (vesting, share count, grant date, contractual expiration, etc).
- Valuation of the underlying asset (stock) as of various grant dates (which usually comes from a 409A valuation)
- Other financial inputs to calculate the optionality value of the options, such as the risk-free rate, dividend yield, volatility of the stock price or comparable basket of stock, etc.
An analyst will then estimate the value of each option grant (since the options are usually not traded and therefore there is no “open market”). The analyst would use an option pricing model (such as the Black-Scholes model) to estimate the value of each grant. We’ll also have to make several different decisions in order to value the different types and classes of grant.
Once the value of each grant has been determined, the next step is to match the expense to the appropriate service period per GAAP (and effectively amortize the option value). What makes ASC 718 reporting complicated is that you need to keep track of every grant activity, their unique vesting schedules, underlying stock value, the inputs needed to estimate the value of each option (risk-free-rate, volatility, etc), and be able to slice and dice it as required by ASC 718. In so many words, it’s more complicated than using an excel spreadsheet and plugging the result into Quickbooks.
Considerations when picking an ASC 718 provider
Something that founders should keep in mind when selecting an ASC 718 provider is that there is no real reason to re-issue your old shares or to get your lawyers involved for stock-based compensation reporting. Your cap table is incredibly valuable, sensitive data, and many firms will try to gain access to your ownership data whenever possible for that exact reason. But in the case of ASC 718, there’s actually no reason to share specific ownership details, beyond the per-grant factors listed above. Contrary to popular belief, sharing your ownership details is not a requirement for audit-defensible ASC 718 compliance, which is why at Preferred Return we don’t require clients to upload cap tables for this type of report.
If you’re expecting to be audited or want to prepare GAAP-compliant financials in the near future, properly expensing your stock-based compensation with an ASC 718 report should definitely be on your to-do list. When it is, shoot us a note at [email protected]—we’d love to chat.