Stock Option Early Exercises: Accounting Considerations

Although stock options have fallen in prevalence among publicly-traded companies, they remain extremely popular among private and recently public companies. One reason is their tax efficiency, as shown by the early exercise feature.

The NASPP blog “Understanding Early Exercise and 83(b) Elections” explains what early exercises are, the advantages of exercising before vesting, and the tax consequences of these transactions. Today, we’ll focus on their accounting implications.

With scale, the accounting behind stock-based compensation becomes increasingly important and can be a major stumbling block when preparing to go public. Early exercise provisions introduce complexity across the spectrum of expense recognition, tax reporting, earnings per share, footnote disclosures, and proxy filings.

Liability Tracking

Since early exercised shares are subject to repurchase until they are vested, companies should set up a liability for the cash amount received from the early exercises.  The liability will be classified as either short-term or long-term depending on whether the vesting date is within one year of the reporting date. The liability is cleared when the shares are vested or repurchased.

Expense Treatment

Exercising options earlier than the vesting date doesn’t mean the required service period has been satisfied. Nor does it mean the employee has full ownership of the shares.

Because early exercised options are fully forfeitable and subject to repurchase, the compensation expense of an award associated with an early exercise should still be recorded over its vesting period. If the vesting condition isn’t satisfied and a repurchase occurs, this is the trigger event for recognizing a forfeiture and reversing previously recorded expense.

Even though repurchasing the early exercised shares upon termination is common, this feature is a company right, not an obligation. In the rare event the company elects not to repurchase unvested and early exercised shares at termination, this results in a Type III modification. That’s because the choice to not repurchase allows the employee to retain shares that would otherwise have been surrendered via forfeiture. In this case, a revaluation of the shares on the modification date is required and the expense would be accelerated immediately, given no further service is required.

Tax Treatment

Typically, equity compensation arrangements give rise to deferred tax assets (DTAs) because book expense is recorded before the associated tax deduction. This applies irrespective of whether there’s an early exercise activity in most cases.

An 83(b) election causes the tax deduction to precede recognition of compensation expense, since the latter is amortized over the requisite service period. This gives rise to a deferred tax liability (DTL). As compensation cost is recognized, the deferred tax liability is gradually reduced to zero and the current income tax benefit is realized.

On the other hand, if the employee terminates before the legal vest date, the company can repurchase the early exercised shares and reverse previously recognized compensation cost. It can also reverse the DTL (with an offsetting credit to current income tax benefit). That creates a permanent difference because the company realized an actual tax benefit without any corresponding book expense.

EPS Treatment

Although the shares may need to be returned to the company if the vesting conditions aren’t satisfied, that doesn’t affect the treatment for diluted EPS reporting. These are still considered potential common shares that enter the denominator of diluted EPS but are not yet basic common shares.

As such, early exercised options are incorporated in the denominator of diluted EPS using the treasury stock method. However, once an early exercise activity occurs and the employer receives cash from the employee to pay the strike price, there are no further hypothetical exercise proceeds. As a result, the only form of proceeds included in the calculation is the unrecognized compensation cost.

Including early exercised shares subject to repurchase in basic EPS isn’t correct because the shares aren’t considered outstanding until the vesting conditions have been satisfied. Upon vesting, early exercised shares are considered outstanding for basic EPS reporting purposes.

Disclosure Treatment

Unvested early exercised shares are considered outstanding for footnote disclosure purposes until one of two requirements is satisfied: (1) the shares are vested and earned, or (2) the employee fails to meet the service requirement and the company repurchases the shares. In the former scenario, the shares become common shares and are included in basic EPS. In the latter scenario, they’re forfeited and no longer outstanding.

The early exercised shares will be included in the beginning outstanding shares of the share roll-forward table. As each portion of the award vests, the shares are earned in the period and, therefore, no longer outstanding as stock-based compensation awards. Many reporting systems don’t track early exercises separately from the regular exercises, thus treating them as exercised and no longer outstanding as of the beginning of the year for ASC 718 disclosure purposes, which necessitate workarounds.

Proxy Reporting

Awards associated with early exercise activity need special treatment for the proxy tables. Early exercised shares that are repurchasable shouldn’t be included in the Option Exercises and Stock Vested Table. This is because options that are early exercised and subject to repurchase effectively become restricted stock awards. That means they belong in the Outstanding Equity Awards Table as outstanding stock awards. Only when they vest are they reported as stock awards vested in the Option Exercises and Stock Vested Table.

Parting Thoughts

Private companies frequently include an early exercise provision in their option plans. The tax incentives are a material benefit to employees and, with the proper employee education and messaging, can be a differentiator when competing for talent.

However, early exercises impact every stage of the stock-based compensation reporting process. When introducing early exercise provisions, be sure to carefully review and adapt procedures relating to expense recognition, tax reporting, EPS reporting, footnote disclosures, and even the proxy tables that are required at an IPO. A rigorous tracking process will help ease the administrative and reporting burden and mitigate the risk of audit surprises immediately before or after going public.