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Explaining Stock Options and Grants and Related Accounting Issues

Stock options and grants are commonly used to compensate and incent employees without requiring any
cash outlay. This allows the employees to share in the appreciation of a business while also allowing the
company to compensate its employees without needing cash on hand (which can be a significant benefit
for early-stage companies that may be cash-poor). When drafting stock option and grant agreements, it
is important that attorneys keep in mind the VALUATION considerations related to both the value of the
underlying stock and any related stock options, which are critical for accounting and tax purposes.

What Are Stock Options and Grants?

While they may sound similar, stock options and stock grants are actually two different equity instruments:

  • Stock Options – Represent the right, but not the obligation, to purchase an ownership interest in a
    company at a specific price over a defined time period (e.g. the right to buy one share of Apple for
    $100.00 at any time during a three-year period).
  • Stock Grants – Represents the issuance of an actual share of stock. Unlike a stock option, which
    requires a cash outlay to exercise the option, no purchase or cash outlay is necessary when a stock
    grant is made – the recipient simply becomes the owner of the shares granted.

Valuing Stock Options and Grants 

  • There are certain differences in the valuation of stock options vs. stock grants:
    Stock Options – The value must be determined using an option valuation model, such as the
    widely-used Black-Scholes model or a binomial/lattice model (which is not as common in practice,
    but offers more versatility in valuation inputs). The value of the company’s shares must also be determined
    to value any options issued since one of the inputs in valuing an option is the value of the
    underlying shares on the grant date.
  • In applying the Black-Scholes model, the following six inputs are required:
    • Fair market value of the underlying stock
    • Exercise price of the option
    • Option term
    • Stock volatility
    • Risk-free rate of return
    • Dividend rate

Therefore, the valuation of a stock option is a two-step process. First, the fair market value of the stock must be determined. Only then can the stock option be valued using an option pricing model.

  • Stock Grants – The value is equal to the underlying stock value on the grant date. This sounds
    simple, but can be difficult for privately held companies without the assistance of a third-party valuation

Stock Option and Grant Accounting Issues

The accounting for equity-based compensation is complex and the inclusion or exclusion of certain phrases can materially impact how the transactions must be recorded. Generally Accepted Accounting Principles (GAAP) require that the “fair value” of stock options and grants as of the grant date be recorded as an expense of the issuer over the related vesting period (based ASC 718 – Stock-Based Compensation).

It should be noted that even though an option may not be “in the money” on the grant date, it will likely still have value when analyzed using a Black-Scholes model because of the possibility that it may be “in the money” at some point prior to its expiration. Therefore, a company’s auditors will likely require a valuation analysis to support the value of both 1) the company’s underlying shares (for any stock grants issued and as an input to value any stock options); and 2) any stock options issued. These valuation requirements create a hidden cash cost for this “cashless” form of  compensation for privately held companies. Therefore, it is important that the company be aware of these additional compliance requirements before deciding to issue stock options or grants.

Continue reading about stock options and grants by downloading our free e-book: Drafting Considerations for Attorneys. 

To learn more about how a business is valued or to gain insight on the financial and economic issues that affect today’s business world, call the experts in the Valuation and Litigation Support group at 440-449-6800. Please email Sean Saari if you would like to learn more about buy-sell valuation considerations.

Drafting Considerations for Attorneys

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