The process for awarding stock compensation is standard enough; you do the legwork required to grant stock options at the correct strike price, you offer those options to your employees, the options vest, and the employees have the opportunity to exercise them.
So what happens if that process is derailed by expired stock options? How would you account for and track expired option grants?
Granting and expensing stock options becomes much more involved on the accounting and recordkeeping side. But why?
Granting stock options is another form of compensation, like a salary, and companies need to account for those options and track them the same way they would a traditional paycheck. Including reporting them to the IRS and in a profit and loss statement (P&L).
In this article, we’re going to show you how private companies can account and track their stock options, including how to account for expired stock options, and more importantly, how to avoid letting options expire in the first place.
Here’s what we’ll talk about in this post:
- What Are Stock Options?
- When Do Stock Options Expire?
- How To Account for Expired Stock Options?
- The Hard Way to Account for Stock Options
- The Easy Way to Account for Stock Options
- How to Avoid Expired Stock Options
Real quick, stock options are a form of compensation that a company grants to employees. Employees are given stock option grants that allow them to purchase shares at a specified price, called the strike price. Those shares translate to common stock in the company.
This method of compensation is typically deployed to incentivize employees. The better the company does, the more the company’s common stock is worth, giving those employees with shares the opportunity to cash in on the company’s success during an acquisition or IPO.
It’s important to understand the details around an option grant’s vesting period. A vesting period is a designated amount of time that needs to pass before an employee can exercise their stock options and convert them into common stock.
For example, if James is granted options with his company, his vesting period may indicate that he receives one-fourth of his options a year for four years, when his grant would be considered fully vested.
Now, that’s just one example. Vesting periods are determined at the time of hire and can be set to vest immediately or over several years or months.
Read more about stock options in one of our other posts:
- NSO vs. ISO – What’s the Difference?
- A Simple Explanation of ASC 718 (123R)
- How to Expense Stock Options Under ASC 718
All stock options expire at some point. There are two scenarios in which stock options expire:
- The time outlined in your stock option grant agreement has passed without the options being exercised.
- An option holder was terminated or left the company before their options were exercised.
The first scenario is fairly straightforward and can be easily prevented, which we’ll explain how to do a few paragraphs down. Basically, every option grant has a stock option grant agreement, that you receive along with your option certificate. It’s sort of like a contract.
That stock option grant agreement has information in it that you need to pay attention to like the number of shares you are eligible for, your vesting schedule, the strike price, and specific provisions (think a non-compete clause), as well as the stock option expiration date. Typically, the stock option expiration is set at 10 years, but that isn’t always the case. You want to make sure you plan for that expiration and not let it sneak up on you.
Keep these informal definitions in mind.
Expired Stock Options – This means the time has run out on your stock option grant agreement.
Canceled Stock Options – This refers to stock options that were vested and not exercised, but it can also reference any current or future unexercised options that you lose when leaving a company.
Forfeited Stock Options – Forfeiture occurs before vesting, usually due to a termination or failure to meet performance conditions. Meaning that if you have unvested stock options and you leave a company, you forfeit those options.
Scenario two is more complicated. Often times in scenario two, expired options are referred to as “canceled” rather than expired. Another term you might hear is “forfeited.” These terms don’t all mean the same thing, but they’ve been adopted and colloquialized into synonyms.
Ok, let’s break down a few of the situations in scenario two.
- We’ll say James is a writer at Company X and he has stock options that are unvested. James decides he wants to write the next great American novel and quits his job. His stock options didn’t expire so much as they were forfeited.
- Now, let’s say James held off on quitting his job for another year and had some vested but unexercised shares. Because his options were vested, they are now considered canceled stock options if James fails to exercise them.
- Finally, imagine that James stayed at Company X for 5 years and exercised his vested stock options into actual shares or common stock in the company. Then James leaves. He keeps his shares because he exercised them, and once you pay or your shares, they are yours to keep.
- Ok, now we’re gonna throw a wrench into this illustration and say that James got an early exercise on his unvested stock options. You can think of this like asking for an advance on your salary. After early exercising his options, James quits. Because his options were unvested and he was given the chance to exercise them early, the company now has the right to buy back any unvested shares.
Makes sense right? If you took out a pay advance and then left, the company would want it’s money back for the work you didn’t do. It’s the same principle in the world of equity compensation.
By the way, when accounting for expired or forfeited stock options, it doesn’t matter if James was fired or quit. Those shares still need to be accounted for.
In short, all of this means that your company likely has some expired stock options which need accounting for. So how do you do that?
There are two ways you can account for expired stock options. The hard way and the easy way…
In order to account for stock options, you need to know the information surrounding those options, like grant date, vesting schedule, number of shares, etc. That means you need to reference your cap table before actually starting the accounting entries.
In olden times, companies tracked their cap tables in Excel. And some of them still do. This is the hard way. Why is this so hard? Because you have to manually track every single certificate, the vesting schedules attached to those certificates and the status of that certificate. Is it vested? Is it exercised? Did you forget to add Joe’s options? Did Joe quit!?
Now you have to go into that spreadsheet and go line by line fixing all these administrative things.
And honestly? It’s a super pain in the neck. It’s error-prone, expensive on your time, and it can very quickly snowball out of control. Once you get even 10 employees, it becomes a lot to manage. It’s also very exposed to circumstances.
For example, if the person managing this spreadsheet isn’t storing it properly in the Cloud, and then leaves, you might lose your entire cap table. That would be very painful.
Plus, if you’re in this situation, you’re likely a pretty early stage company and could be spending your time attracting investors and developing your business instead of updating an ugly spreadsheet all the time.
What is an ASC 718 Expense Report?
ASC 718 is a section of the Accounting Standards Codification (ASC) which outlines expensing stock-based compensation, such as option grants. In order to be US GAAP compliant, your company needs to follow the guidance in the ASC, including section 718.
Here’s a simple explanation of ASC 718 from one of our other posts.
Do You Need to Do An ASC 718 Expense Report? You need to complete an ASC 718 Expense Report if you have employee equity grants and you have audited financials. Employee equity can include options, restricted stock awards, restricted stock units, stock appreciation rights, etc.
Also, it’s worth mentioning that in order to get an accurate P&L, you’ll need an up-to-date ASC 718 expense report. And you’ll need that P&L for a lot of reasons, like bank loans, board meetings, the IRS, new financing rounds, etc.
How Do You Get an ASC 718 Expense Report?
In order to get your ASC 718 expense report, continue to Step 3 and walk through each section until you have a total stock compensation expense figure to book in your ledgers.
If you are going to go about accounting for expired, canceled or forfeited stock option grants using the hard way, here’s what you’d have to do:
1. Collect The Necessary Data For Each Option Grant
- You will need to know the grant date, vesting schedule, and number of shares for each option grant.
2. Calculate The Fair Market Value (FMV) For Each Option Grant
- To find the FMV, you need to use either the Black Scholes or Lattice Model. Both of these methods involve multiple inputs like the underlying value of the common stock, volatility, risk-free rate, and the expected term.
- Under ASC 718, FMV must be calculated as of the grant date of each option, so grants with different dates need individual calculations.
- There are also differences in employee grants vs. non-employee grants. For employee grants, FMV is calculated on the grant date, so you only have to calculate it once. However, for non-employee grants, FMV has to be recalculated at least every reporting period, which is usually done annually.*
*Non-employee equity grants need to adhere to ASC 505-50, which outlines how to account for this type of compensation expense.
3. Multiply The FMV By The Number Of Options You Are Reporting
- Once you have calculated the FMV of each option grant, you need to record the aggregate FMV over the period.
- Options are expensed over their useful life, which is typically defined as the vesting term. To determine the aggregate stock expense, multiply the FMV of each grant by the number of vested shares in that grant, and sum the total.
4. Add a Journal Entry to Compensation Expense and Additional Paid in Capital (APIC)
- Stock options have to be expensed the same way traditional compensation is.
- Make a debit to your compensation expense and a credit to APIC.
5. Reverse that Entry if Necessary
- Depending on when an option is canceled, forfeited or expires, you’ll potentially need to make several updates to your ledgers:
- For unvested, forfeited options; you’ll need to account for any portion of forfeited options that was expensed previously. Some companies only book expense as the options vest, but under ASC 718, the company should attempt to expense some portion of the unvested shares during a cliff period, often applying a forfeiture rate to predict the likelihood of forfeiture. This portion will need to be reversed, either immediately or as an adjustment in next year’s expense if those expensed shares ultimately do not actually vest.
- See the illustrations below for a better understanding of when to expense and reverse stock options.
6. Make Note Of The Options Cancellation On Your Cap Table
- Ensure you properly remove the options from the option pool or send them back to the option pool according to the disclosures in your company’s equity plan.
- Make sure that this transaction is tracked across all versions of your cap table data.
7. Communicate The Change To The Previous Option Holder
8. Keep A Record Of These Changes And Transactions For Your Audited Financials
You could also pay an accounting firm and outsource the expense portion of this work, but that can get expensive.
If all of that sounded miserable, you can relax. There is a much easier way to account for and track expired stock options, and track all your stock options and equity.
If you use a cloud-based equity management software, like Shareworks Startup Edition, you can simplify the entire process from granting stock options to tracking and reporting them.
Here’s what tracking stock options would look like on startup edition, including expired stock options.
Screenshots from Shareworks Startup Edition
Canceling an Option:
Starting from a fully uploaded cap table.
1. Select the certificate you want to make changes to.
2. Click “Actions”
3. Select “Cancellation”
4. Set the details (number of shares, vested or unvested, the date and the reason)
Save the changes and you’ll see them under “Transactions”
Once your cap table is uploaded, the software automatically tracks everything. So, if you had an expired or canceled stock option, the software manages the math, regulations, tracking, etc for you, based on preferences you set.
For example, cancelled options can return to the option pool or be removed from the option pool, based on what you indicated in your equity plan, and the software will automatically perform that change for you.
Another reason managing your equity in a platform like startup edition is so beneficial is because when it’s time to expense stock options, it’s a very simple five-step guided workflow to generate a stock option expense report, and expired options will be automatically calculated into it because your cap table is up-to-date.
Our report also gives you the exact compensation expense figures to book as well as footnotes and disclosures that you wouldn’t get if you did your expense reporting the manual way. Our report also calculates employee grants and non-employee grants in one report so you’ll be compliant with both ASC 718 and ASC 505-50.
To complete step three, you need to enter the expenses from your startup edition ASC 718 stock expense report in your journals and then reverse entries if necessary, as we outlined above. The easy way to do this is to use the specific data the solution provides to make the journal entries.
If you’re using software to manage your cap table, you’ll find all the smaller steps that go into making that journal entry are considerably easier because you don’t have to struggle to calculate FMV for each option grant or manually search for vesting schedules, grant dates, etc. You just log in to your online cap table and all that information is neatly organized and available at a click.
What if I Already Tried it the Hard Way?
For the sake of discussion, let’s say you already have a really messy spreadsheet tracking your equity, and it’s making it very hard for you to account for your stock options. What can you do to right this wrong?
You can give startup edition the current spreadsheet, in all its disorganized chaos, and our expert Services Team will upload it, process all the terms, cancellations, forfeitures, vesting schedules, valid options grants and shares, etc. Then, they’ll return to you a beautiful, intuitive cap table that investors will be impressed by and shareholders will be excited to see.
Then you can use that cap table to help you cut out a lot of the painful record management when you account for the stock option grants in your journals.
You can see that accounting for stock options can be tricky if not done properly, especially if options expire or are canceled. And it’s not just a pain for your accountants. It’s not good for your employees.
If your employees let their stock options expire, they’re pretty much out of luck. Unexpected expired options can be horrible for important employees’ morale, especially if the grant had become meaningfully valuable.
So what can you do about it?
That means keeping your employees educated on the rules surrounding their equity.
When you grant stock options, it’s vital that your employees know your stock plan rules. For example, some companies require that employees with vested stock options exercise those options within 90 days of their departure, or their stock options become forfeit.
If you haven’t already, you should decide what your stock option plan rules are and make sure your employees are made aware of them.
With Shareworks Startup Edition, you can define the expiration policies for unexercised shares on your cap table. You can choose to expire shares immediately upon termination for cause, 90 days upon termination without cause, 365 days after death or disability, etc.
Another way to avoid expired stock options is to keep your equity properly organized and managed.
You should be tracking all your equity, including stock options, and the best way to track equity is using a cloud-based software as a service, rather than a spreadsheet, because it automates a lot of the little details that might otherwise slip through the cracks, like expired stock options.
Using software to manage your cap table, you’ll end up with a much smoother process for granting options, forecasting changes to your equity and experimenting with new option pools.
Here are a few benefits to managing your equity in our cloud-based software:
- It’s Safe – Your information is protected and your data is always yours to export at any time. Plus, your documents are in the Cloud, so you’re protected from data loss and mismanaged documentation.
- It’s Easy to Use – The software was built by people who work with equity and cap tables every day. The intuitive design simplifies the whole process of equity management and turns hours of work into minutes.
- It’s Flexible – Startup edition offers the only equity management software that can accept certificated and uncertificated shares, which means you don’t have to reissue paper certificates to digital ones. As you can imagine, that would be an ugly and time-consuming process.
- It’s Customizable – You can control who sees what. You can give shareholders permission to see the whole cap table or only their shares. And since shareholders have their own login and portal, you won’t be responsible for corralling the latest version of the cap table and sending it to everyone who requests to see their equity. This access also keeps shareholders aware of what’s happening and educated on their equity.
- It’s Smart – The built-in auditor catches mistakes and alerts you to problems in your cap table, and with a change history, you can see exactly who changed what and when so you can catch faulty versions. It’ll also tell you the future…really. Using scenario modeling tools, you can forecast changes to your equity before making them, like comparing investor terms, adding options to the pool, etc.
- It’s Automated – The intuitive workflow automates the back and forth of issuing and approving options grants. The software will track the stages in the workflow and send messages to lawyers, shareholders or C-level members of the team based on who is holding up your pipeline.
It may sound obvious, but your equity is really important, and not treating it that way can cost you and your employees later on. Which is just one reason why so many companies are changing the way they manage their equity and migrating to a cloud-based software as a service like startup edition.
If you’re ready to join the 10,000+ companies already managing their cap table on our platform, schedule a demo today.