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Accounting Standards Codification (ASC) Topic 718, issued by the Financial Accounting Standards Board (FASB), prescribes how companies
should account for stock-based compensation to employees, for example stock options or profits interests in limited liability companies,
to be in compliance with U.S. Generally Accepted Accounting Principles (GAAP) accounting. With respect to equity awards such stock options
issued to employees, their value must be accounted for as an expense in the income statement of the company. Similar rules for non-employees
are provided in ASC Topic 505-10.
GAAP accounting is used for audited financial statements in the United States but is not a requirement for all companies. Very early stage
companies, such as those in a Seed funding stage, will often not have audited financial statements given the cost and time required for these.
However, companies in later stages of development or established companies with multiple investors will generally have audited financial
statements and will therefore need to consider ASC 718 if they provide equity incentives for their staff.
For valuations under ASC 718 the valuation standard used is Fair Value, as defined in ASC 820 - Fair Value Measurement. This standard is in
many ways similar to Fair Market Value, which has been defined by the Internal Revenue Service, but does have some material differences.
In order to value grants of standard stock options under ASC 718 the Black-Scholes-Merton option model is normally used, with the current stock
price and exercise price commonly derived from a recent 409A valuation for the company. The other inputs are a) time to maturity based on
vesting and expected exercise of the options (rather than the contractual term for the options; b) a risk-free rate based on the time to maturity;
and c) a volatility based on an analysis of the equity volatility of guideline public companies. For companies that pay dividends, the dividend
yield would be an additional input.
For non-standard options and other forms of equity awards, the Black-Scholes-Merton model cannot be used. Instead, we can use a Lattice
(e.g. binomial) model or Monte Carlo simulation. For example, while the Black-Scholes-Merton model needs to use an expected time to exercise,
the Lattice model can accommodate specific assumptions for suboptimal exercise behavior or post-vesting termination. Also, for awards that
depend on external market conditions a Lattice model or Monte Carlo simulation must be used.
Once the Fair Value of the equity awards have been determined, the expense for the company can be calculated with the value amortized over
the vesting period. For example, if stock options have a 4-year monthly vesting, then the annual expense will represent 25% of the equity
award Fair Value.
To discuss your potential ASC718 valuation need, please email us at windeye@windeyepartners.com or contact Certified Valuation Analyst Michael Guthammar on telephone (929) 223-2935.