We speak with CEOs all the time who have this question. We intend to use this post to give a nuanced but in depth answer that can help you determine whether you need to spend the time and money to expense your stock options.
We're not going to spend much time on the general methodologies for expensing your stock options. If that’s your question, check out this article.
Let us also tell you that towards the end of this article is a simple checklist to determine whether you need to expense your options. You can skip to it right now if you want, but you’ll miss out on some explanation and context.
Free Guide: Download “How Expense Your Stock Options Under ASC 718”
Okay, let’s dive into some simple points you should understand in order to determine whether you need to expense your stock options:
Option Expensing is a Requirement for GAAP Compliant Financials
“…for I the Lord thy God am a jealous God” (Exodus 20:5).
This verse comes from the part where Charlton Heston is receiving the 10 Commandments up on Mount Sinai. You know…”Thou shalt not kill, steal, forget thy wedding anniversary, etc.”
The Financial Accounting Standards Board (FASB) is much like the God of the Old Testament. And FASB’s version of the 10 Commandments is called Generally accepted accounting principles (GAAP). Oh, and it’s more like their 10,000 Commandments.
But the “jealous” thing is the part we wanted to focus on here. You don’t get to pick which parts of GAAP you choose to follow. You either follow them all and are “GAAP compliant” or you are not. FASB is a harsh taskmaster.
Publicly-traded companies on major US exchanges are required to be GAAP compliant. A lot of private companies, however, are not. Mom and Pop shops frequently use cash-based accounting. In the early days of your start-up, you might have done the same too. But most investors prefer their companies to follow GAAP, and so by the time you have raised a round of funding, you are almost certainly following GAAP.
So if your auditor is telling you that you need to expense your stock options, this is probably why. You are maintaining GAAP compliant financials, so it’s just something you need to do.
But what is Stock Option Expensing?
In the words of PricewaterhouseCoopers (PwC), “The fundamental premise of…Stock Compensation, requires that companies recognize the fair value of employee stock-based compensation awards as compensation cost in the financial statements, beginning on the grant date“ (section 4.2 paragraph 1 of Guide to Accounting for Stock-based Compensation).
In plain speak, the options (or other equity-based awards) you are issuing to employees are a form of compensation. So just as you expense an employee’s salary, you need to expense any options issued to them as well.
Without getting into the weeds, you must come to a fair value for the option (and it’s not as simple as just using the strike price). Then you expense the grant over the useful life (generally the vesting period). This is akin to how you depreciate property, plant, and equipment over their useful lives.
But again, it’s not quite this simple – we're leaving out a lot of details. For a deeper look, click here.
ASC 718 and ASC 505-50
When talking about stock option expensing these nonsensical letter/number combos often get thrown around like they should mean something to you. They may not have before, but now they will.
ASC 718 and ASC 505 are the two GAAP “commandments” that govern the rules for expensing stock-based compensation awards. ASC 718 contains the rules for expensing stock awards to employees. ASC 505 subsection 50 (or ASC 505-50) does the same for non-employees.
Within the industry, we often just use “ASC 718” as an umbrella term for all of stock option expensing, but that’s technically incorrect for two reasons. As mentioned above, ASC 505-50 governs the rules for non-employees. Additionally, ASC 718 covers the rules for expensing more than just options – it covers RSUs, RSAs, liability awards, etc.
It’s a bit like calling all automobiles “cars.” Speaking precisely, there are trucks, motorcycles, tractor-trailers, cars, etc. and they are all types of automobile. But when you get out on the road, most things are “cars” and so we just often just speak of “cars.” Most equity awards are stock options to employees, and so we speak of “ASC 718” instead of “ASC 718 and ASC 505-50.”
Occasionally you also hear “123R” being thrown around. 123R is technically defunct – it was rolled into ASC 718. But the name lingers. When people bring up 123R, they are basically just referring to ASC 718 under an old name.
The Checklist – Do I Need to Expense out my company’s equity-based awards?
1. If you have issued any equity-based awards, then stock comp expensing is something you likely need to do. Here are some of the most common examples of equity-based awards:
- Stock Options (ISOs and NSOs)
- Stock Appreciation Rights (SARs)
- Restricted Stock Units (RSUs)
- Restricted Stock Awards (RSAs) where the recipient did not pay fair market value for the shares.
2. If your company has issued any of the above or any other type of equity-based compensation award, and you can answer “Yes” to either of the following questions, then you need to expense your company’s equity awards:
- Did your auditors tell you that you need to expense out your stock options?
- Do you maintain GAAP compliant financials?
3. If for any reason, there is any ambiguity in your answers to the above two questions, here are a couple of other indicators that you need to be expensing your stock options. Can you answer “Yes” to any of the following:
- Have raised a priced equity round (Series Seed or Series A)?
- Are you preparing for an Initial Public Offering (IPO)?
- Have you issued any equity-based awards in the past five years?
Download our guide, “How Expense Your Stock Options Under ASC 718”
Getting Started with Stock Comp Expensing
If after reading the above, you realize that you need to be expensing your equity awards (such as options) but are not, please don’t fear. Getting it taken care of doesn’t have to be the end of the world, and you have a couple of options:
- DIY – Yes, you can go-it-alone and do-it-yourself. Although stock comp expense is something that is learnable, this is likely not your best option. You’ve got a lot of things to juggle, and becoming specialized in something like this may not be worth your time. It’s likely cheaper to pay someone else to handle it so that you can move on to bigger fish.
- Outsourced CFO/Accounting Firms – If you have outsourced any of your accounting to a third party firm, you can likely pay them a little extra and have them take this burden off your back.
- Auditors – We often find that a company’s auditors are willing to help the company expense their options. Generally, it’s not their favorite thing to do for two reasons. First, they don’t specialize in it. Second, there is the problem of them auditing their own work. That being said, auditors will often do it anyway for smaller companies.
- Shareworks Startup Edition – Of course we had to mention this option! We have built some great software, and have an experienced team to assist you. We are happy to take auditor questions and we really do our best to make it so that stock comp expense is something you don’t have to stress over. We are also generally quite a bit cheaper than your other options (thanks to the power of software). This is doubly true if you have past years of expense that you haven’t recorded and you need help getting caught up on. Feel free to check it out here.
One final note on “materiality” and when we’ve seen companies not expense their options
As we've tried to make very clear in this article, stock comp expensing is simply something you must do under GAAP (ASC 718 and ASC 505-50). However, if you aren’t worried about having GAAP financials, then you probably don’t need to worry about it just yet.
We simply wouldn’t be telling it straight if we didn’t mention that we frequently encounter companies that have issued options or some other form of equity awards and they are not calculating the expense.
Usually, these companies are in the earliest of early stages (a handful of team members in a garage). There are just a couple of option grants issued and the company isn’t worth much. Therefore, the options aren’t worth much either – the expense just isn’t material. Understandably, the company can’t justify spending a couple thousand dollars to accurately record an expense that might amount to a couple hundred dollars.
If you fall in this category, then generally speaking, stock option expensing is something you probably don’t need to worry about. But it is something you should revisit once you’ve raised a priced equity round (Seed or Series A) or even just raised significant funds through convertible notes.
A parting word of caution
Despite what we just said, we’ve seen too many companies push it off too long, and they end up not recording stock comp expenses of $100k or more. They then have to go back and restate past financials, which can be quite the headache. Do not wait too long to start doing things the right way!