Question 3: What are the accounting implications of employee equity compensation programs?
Another major challenge for many tech startups is the need to attract and retain talent in a tight market, particularly when the company has only limited cash flow available. Offering an equity stake, either immediately or in the future, can be a powerful recruiting tool, with the added benefit of incentivizing employees to focus on performance and adding value to the organization.
Financial reporting considerations
Although the financial reporting complications associated with these offerings are sometimes a little simpler than those arising from some equity financing arrangements, they nevertheless should be considered when company management sets up such programs.
Equity compensation arrangements can be structured in various ways. Among the most straightforward are outright grants of shares of stock or restricted stock, which allow employees to gain an ownership stake in the company once they have worked for a specific duration or achieved certain performance targets.
Stock options, on the other hand, become equity in the company when employees exercise their options to purchase shares once the options are vested. Vesting provisions – such as time vesting or achieving performance targets – are spelled out in the grant, as are various other details. Other common option terms include a specified exercise price, option expiration dates, market conditions, and any required waiting period before an option holder can resell any stock acquired.
While many companies are familiar with accounting for stock or stock option grants, another form of equity compensation that is prevalent in pass-through entities, such as partnerships or limited liability companies, is a profits interest grant. Profits interests are a special class of equity in a pass-through entity that provide a vested grantee an opportunity to participate in distributions of future profits and/or appreciation in the net assets of the issuing entity (but not existing capital). Profits interests are complex arrangements to account for because: 1) they can feature a variety of different terms and appear similar in form to stock options, stock appreciation rights, restricted stock, or profit-sharing arrangements, to name a few, and 2) U.S. GAAP does not provide explicit guidance covering the scope and accounting for profits interest awards. When evaluating the accounting for profits interest awards, management needs to consider all relevant terms and features of the award to determine whether the instrument represents a substantive class of equity. Profits interest awards that represent a substantive class of equity are accounted for under ASC Topic 718, “Stock Compensation,” and might be classified as equity or a liability based on specific classification guidance in Topic 718. On the other hand, profits interest awards that are not a substantive class of equity typically are accounted for as a performance bonus or profit-sharing arrangement pursuant to guidance in ASC Topic 710, “Compensation,” and classified as a liability.
Determining the scope and accounting for profits interests can be complex and requires judgment. Often, the analysis focuses heavily on what happens to a vested award when the grantee voluntarily terminates employment. That is, do grantees that terminate employment maintain the right to keep the vested award and participate in distributions regardless of employment status, or do they lose their right to benefit from the award – through either forfeiture or a company-controlled call option at a nominal value? Settlement terms also typically factor into an entity’s analysis of a profits interest award. For example, some awards permit or require settlement at fair value, while others might settle at an off-market or formula value. Likewise, some awards explicitly require cash settlement, while others are silent or provide the entity with the ability to control whether the award is settled in cash or equity. In some cases, profits interest awards that are accounted for under ASC 718 and would otherwise be classified as equity might still require liability classification, either initially or subsequently, if the issuer demonstrates a past practice of cash settlement of such interests within six months of vesting.
Companies that offer equity-based compensation arrangements sometimes overlook the accounting implications, believing that there is no need to recognize the award on the financial statements. This might be because there is no cash implication at issuance, because the award is not in the money at issuance, or even because the award will not be monetized until it is settled, which might not happen until there is a change in ownership. To be GAAP-compliant, however, companies should recognize that employees who are granted equity-based awards receive something of value at the time of the grant in exchange for the employee’s service, and the company should record an appropriate expense over the requisite service period if those options probably will vest in the future.
Again, the critical question is whether the option should be recognized as an equity item or a liability. If a share-based payment is classified as equity, it is measured at its fair value on the grant date and recognized as compensation cost as it is earned. Depending on how the company structures the award, however, it could be classified as a liability, in which case it would need to be revalued each reporting period until it is settled. This often is the case when awards include an employee-controlled redemption option (that is, a put option); when companies have a history, based on relevant facts and circumstances, of cash-settling options or immature shares (that is, within six months of a share becoming vested); or when awards provide for off-market settlement.