If your business offers stock-based compensation, also known as share-based compensation, as a benefit of employment, Kei Morita has advice. A principal in the Los Angeles office of HCVT, a top 30 CPA firm, Kei has extensive experience providing audit and assurance services to closely held private companies, particularly those in the tech industry. Here, he answers our pressing questions.
Connecticut Innovations: Thanks for agreeing to this interview, Kei. Let’s dive right in. What are the common ways you see tech startups structure stock-based compensation?
Kei Morita: Restricted stock units and stock options with service conditions are the most common. Even with plain-vanilla features, accounting analyses for share-based compensation can get complex.
CI: Do you have tips for choosing the best type of SBC, from an accounting and reporting standpoint?
KM: The easiest SBC arrangement from an accounting perspective is one that contains no performance conditions, such as EBITDA [earnings before interest, taxes, depreciation, and amortization] target vesting, or market conditions, such as MOIC [multiple on invested capital] target vesting. If you include put [redemption] or call [repurchase] features in an SBC arrangement, those may complicate accounting analyses even further.
CI: Are there common mistakes you see early-stage tech companies making when they offer stock-based compensation?
KM: I occasionally see early-stage companies offer SBC awards without considering the tax implications—payroll tax withholding requirements, taxable awards, etc. This often results in the company owing back taxes and penalties. I strongly advise early-stage companies that offer SBC awards to consult with their tax advisors when structuring these awards. I also see startups repurchase vested or unvested SBC awards when employees leave. With that practice, SBC may need to be treated as liability-classified awards, which would need to be fair-valued in each reporting period—that is, every time the financial statements are prepared.
CI: How can early-stage startups with limited resources better prepare to handle complex accounting and financial reporting for stock-based awards?
KM: Until GAAP-based financial reporting becomes a requirement, many early-stage companies won’t account for SBC awards under GAAP. However, it is imperative that companies maintain complete records from the beginning to avoid any tax or legal issues. Depending on the number and frequency of SBC awards they issue, it might be a good idea for these companies to use a cloud-based equity management platform to track the SBC award activities for accounting and legal purposes. It often gets too complicated to maintain SBC awards in spreadsheets, especially when the awards are issued frequently, or features differ from award to award.
CI: Why did the FASB and the Private Company Council issue new guidance on share-based awards last year?
KM: In general, SBC needs to be fair-valued at the grant date using a valuation technique such as an option-pricing model (e.g., Black-Scholes), which requires various inputs, including the fair value of the equity shares underlying the award. Based on its outreach and the feedback it received, the Private Company Council (PCC) learned that determining the current price input used in an option-pricing model is typically the most difficult task for private companies. Since private company shares are not actively traded, there are no observable market prices for those shares, so the PPC decided to provide private companies with a practical expedient to ease the cost and complexity of applying accounting guidance for all equity-classified SBC awards under ASC 718. The FASB issued ASU 2021-07 to allow private companies to elect this practical expedient in 2021.
As a practical expedient, a nonpublic entity is allowed to determine the current price input of equity-classified SBC awards using the reasonable application of a reasonable valuation method. This includes a reasonable valuation performed in accordance with the U.S. Internal Revenue Code, also known as a 409A valuation.
CI: What has been the result?
KM: Many private companies historically obtained a 409A valuation for tax purposes and adjusted the valuation for ASC 718 accounting if subsequent events or transactions changed the valuation.
As a result of ASU 2021-07, some private companies may have reduced cost or complexity, as the PPC intended. However, since many private companies had already used a 409A valuation with or without adjustment before this ASU came out, and since other ASC 718 accounting complexity still exists, I have not seen many private companies consider the practical expedient a game-changer under ASU 2021-07.
CI: At what point is a company required to become GAAP-compliant? How can it do so?
KM: Prior to obtaining outside financing, many technology startups and other early-stage companies simply ignore the accounting for SBC awards. But as companies raise larger funding rounds—typically in the Series A or B round—they will need to be audited and must become GAAP-compliant. Before raising a Series A, an early-stage company should implement GAAP accounting even when GAAP reporting is not required. Many companies with a Series A retain a CPA consultant or a future auditor to assist them in making their books GAAP-compliant soon after Series A is raised.
CI: What are some of the critical stock-based compensation accounting and reporting considerations a company should be aware of?
KM: At a high level, a company should be aware of two classifications: one, liability-classified awards, and two, equity-classified awards. Liability-classified awards need to be remeasured at fair value at each reporting period, whereas equity-classified awards do not require remeasurement unless SBC awards are modified.
Various features embedded in an SBC award, such as put and call options, may cause the SBC award to be liability-classified. Also, depending on vesting conditions, the amount and timing of SBC expense may differ. SBC awards with service conditions without performance or market conditions are expensed over the requisite service period. SBC awards with performance conditions are recognized only when it is probable—about 75 percent likelihood—that the conditions are satisfied, and therefore, SBC awards vest. SBC with market conditions requires a complex valuation model, such as a Monte Carlo simulation model, to value, and are typically recognized regardless of achieving such conditions.
CI: What can companies that aren’t GAAP-compliant do to prepare for larger rounds, exits, etc.?
KM: Common accounting challenges in many tech companies are related to revenue recognition, leases, equity and debt arrangements, and SBC. Accounting analyses for these areas may require significant time and effort to become GAAP-compliant. Thus, it’s advisable to retain a CPA or a future auditor for GAAP conversion as soon as a Series A is raised, rather than waiting until GAAP reporting is required.
In a typical transaction, a buyer requires two- or three-year comparative GAAP financial statements from the seller that have been audited by a nationally recognized accounting firm. Generally, when the seller’s books are GAAP-compliant, a single-year audit process takes two to three months, and a two-year audit process takes three to four months. When the books are not GAAP-compliant before an audit begins, it can take several more months to get the books ready for audit. Larger rounds may come with a tight due diligence period—for example, three months—so if books are not GAAP-compliant when a Letter of Intent is signed, it can be challenging to complete the audit process within the expected timeline.
CI: Anything else you want to mention to our tech entrepreneurs?
KM: SBC awards vary from company to company, and there is no one-size-fits-all solution from an accounting perspective. Suppose a company does not have a GAAP-experienced CPA in its accounting department and it needs to account for SBC awards under US GAAP. In that case, the company should consider retaining an outside consultant sooner rather than later to track SBC awards correctly and to account for them properly under ASC 718. Generally, tech companies are C-corporations. There are likely other transactions, such as convertible debt, SAFE [simple agreement for future equity], and preferred equity instruments that come with GAAP implications. I suggest early-stage companies obtain help with accounting analyses for these debt or equity instruments, since they can be even more complicated than SBC accounting.
CI: Great advice, Kei. Thanks for sharing all that with our audience.
KM: My pleasure.