What to expect when Expensing?

how to avoid stock-based compensation report’s most common mistakes

Reading Time: 4 Minutes

Most high-tech companies and startups’ yearly financial statements, probably contain an expense for any stock-based compensation given to employees and others. Whether they wish to create the report internally (via CFO or so) or with the help of a professional company, the process remains the same and is often tricky.

 

Step one of the process usually contains an economic  assessment of the value of all stock-based grants, including vested and unvested stock options. then as step two, a correlation to that value is made throughout a time period, specified by the contracts and grant letters. To put it in simpler words: we calculate what is the total worth of any stock-based grant ever given and lay it on a timetable.

One of the more common events in which the stock-based compensation report’s bottom line varies, and will affect the entire financial report balance, is commonly called a modification. Generally speaking, modification means a reevaluation and assessment of the stock-based compensation expense.

When talking about modification, most will probably think of Repricing - a dropdown for stock options buy-in price, specified in the grant letters given to employees and such. This common phenomenon usually occurs when a company’s assessed stock worth drops, and the buy-in price offered to employees needs an update in order to stay attractive. Though a repricing process counts as a modification, they are not the same, a repricing is merely a fraction in the deep sea of modification.

 

Companies might unknowingly neglect some processes that also go under modification and will lead to a false financial report. This problem might surface by the audit team and in this better scenario will cause a back and forth with them as well as many useless hours spent on solving the issue. The worst-case scenario will meet a company at the end of the road, and might be an entrepreneur’s worst nightmare: a long delay in the yearned Exit at the end of the road. This delay can be interpreted by future investors and stock traders as a high risk, they can hesitate and think more than twice before joining the party.

So what are the other processes that sit under the definition of modification? Here are three that are actually highly common and often fall between the seats:

 

Expected term modification

A stock-option compensation or grant usually has two time periods specified in any given grant letter: The first, define the actual grant’s benefits expiration date (commonly set to ten years from signing). The second, specify the grace period in which a person can buy a vested option, offered to him after he is no longer an employee.
Because the readjust of those time periods implies a change in the total worth of the company’s stock-based compensation options over time, it is considered a modification and should be addressed as such.

 

Change in Grant Letter Condition

When a grant condition gets a statistical upgrade towards its financial probability it is considered as a modification.
Generally speaking, there are three common stock-based grant conditions - Grant by Market(unexpected statistical scenario), Grant by Performance (good statistical scenario), and Grant by Service (the best statistical scenario - “A Sure Thing”).

Grant by Market is the statistically unexpected of the three, it means the person will receive a vested amount of option if, and only if, the company will one day come close to an Exit or Liquidation.
Grant by Performance is more possible and easy to acquire, it defines a number of vested stock options to be given every time an employee hits a target mark (set in his approved grant letter), this is mostly given to people specializing in sales or other achievement-based positions.
Grant by Service is the last but certainly not least, as it is the most popular among the three. It basically means a person will receive an unvested stock option that will gradually vast upon a service given to the company. The most common example is employment - you will work for me, and every specified period a percentage of that predetermined unvested options will become vested.

 

Capital Structure Change

When a small private company merges with a larger one (private or commercial) the price of each company’s stock is probably different. The uneven worth is called a difference in the  Incremental Value, which is also considered a modification.

At the end of the day, the yearly SBC expense report might be hard at first but don’t let it overwhelm you. With the right approach, it can be done with ease and mistakes-free. The report for stock-based compensations is an important part that shouldn't be mistreated or abandoned. It is probably the best option to acquire the assistance of a company that specializes in this kind of thing and will smoothen down this sometimes hard-to-swallow pill.

 

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