As a growing private company, you likely understand the advantages (some say necessity) of granting stock options and other forms of equity compensation to employees and consultants. Equity awards attract talent, motivate staff to grow corporate value, and, with strategic vesting periods, they help retain the talent you need to fuel innovation. And in some industries, they’re simply an expected component of total compensation. Yet, the fact that equity compensation is so omnipresent among private companies doesn’t make it any easier to manage, and the expensing piece is often regarded as the thorniest of issues.
When back-of-the-envelope calculations no longer count
The rules are clear: regardless of size, US private companies must follow ASC 718, the US accounting code that prescribes how companies account for share-based payments. In practice, though, smaller private companies (say, seed through early stage) tend to follow the rules roughly at best. Sometimes that’s due to lack of awareness, while other times it’s a known issue for startups that simply can’t afford the kind of expertise it takes to achieve audit-ready compliance. It’s also common knowledge that many investors accept an eyeball fair value, a practice regarded as passable. Given the lack of public disclosure required for private companies, there’s also a correlating lack of scrutiny on their accounting processes.
Greater growth, greater expectations
But, here’s the thing. For startups, formal compliance can seem like a burden – especially when no one seems to be watching. But significant growth changes that. Are you on the verge of a major financing round? Are you bidding for government contracts? Do you have a product or service in the works that will be a major market breakthrough? Your company can be rocketed into an audit situation without warning. Depending on assets and number of shareholders, your company can even be required to comply with public company reporting standards while still private. If an exit is in the cards, anything but well-maintained books will be a liability. And if it’s an IPO that you’re targeting, you can expect a lot of scrutiny by the SEC and the IRS.
Your first disclosure as a reporting company (far off as that day may seem) will account for that year and the previous two, so you’ll need a trail of defendable data for at least that amount of time. If you haven’t been fully complying with ASC 718 and the special allowances that are afforded to private companies under SAB 107/110, this evidence will probably be lacking. And no one wants their first disclosure to require a restatement.
Making the case
The rules under ASC 718 can be tricky. In addition to conducting a proper valuation using an option pricing model, you’ll need to determine the total expense of your option, and select a method for recognizing that expense over their vesting periods – so that your house is in order when you eventually have to make disclosures as a reporting company.
Yet, despite the complexity, ensuring proper early accounting compliance can actually simplify an IPO or exit, prove that you’re serious about corporate governance, and provide your investors and other stakeholders with greater confidence in your business overall. As an added benefit, when you’re a publicly traded company, you’ll enjoy a leg up when it comes to the CEO and CFO certifications that all public companies must make regarding the accuracy of financial disclosures. In essence, corporate officers of public companies are under a fiduciary duty to ensure that all disclosures are accurate and complete – including those that cover option expensing. If a company is forced to issue a financial restatement, the CEO and CFO can face regulatory penalties, legal liability and even termination.
Seen in that light, the case for properly valuing your equity compensation from the outset becomes clear. A little extra effort now can save you serious stress in the future, while delivering a measurable payoff as your company hits its growth stride.
Just do it
Of course, once you decide to comply with ASC 718, you still need to determine what model to use to value your options. Next in this series, we’ll contrast and compare various methods so you can choose the one that’s right for your company.