Stock Option Early Exercises: Accounting Considerations

As part of a broader series on pre-IPO equity compensation and how companies navigate compensation strategy and financial reporting decisions, this blog will discuss how stock option early exercise provisions function and the complexity they pose to downstream accounting and administration.

Although stock options have waned in prevalence among publicly traded companies, they remain extremely popular among pre-IPO and newly public companies. One reason is their tax efficiency, such as through an early exercise feature.

We’ll begin with a brief overview on how early exercise provisions work, then focus the rest of our discussion on the technical accounting and reporting challenges companies must consider when incorporating this highly valuable feature.

Introduction to Early Exercise Provisions

Early exercise provisions let option holders exercise all or a part of a stock option award prior to vesting. Both incentive stock options (ISOs) and non-qualified stock options (NQSOs) can contain early exercise provisions. However, such a provision must be approved by the board of directors either upfront in the grant agreement or via subsequent modification.

Electing to early exercise a stock option requires the employee to pay the strike price before vesting date in order to acquire the shares. For very early-stage companies, this might be a reasonably insignificant amount—but, of course, not always.

The benefit to early exercise is locking in little to no tax since the intrinsic value at or near the grant date will be close to zero. By filing an 83(b) election, you also avoid incurring a tax obligation on the vesting date.

In short, this sequence of events allows employees to have virtually all their gain on the option taxed at the long-term capital gains tax rate. In fact, the early exercise even simplifies the effort to satisfy the one-year holding period requirement underlying long-term capital gains treatment.

There are some catches to early exercise provisions. There’s no refund from the IRS if the employee subsequently leaves and forfeits their awards when an 83(b) election is made. However, early exercise programs include repurchase provisions whereby the company will repurchase unvested options at the lesser of the then-current 409A price and the strike price.

For all these reasons, an early exercise provision is a feature commonly included in the equity compensation packages that pre-IPO companies offer, with the intent of providing tax-efficiency. However, 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. We’ll discuss these one by one in the sections below.

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.

Some administrative and reporting systems lack the functionality to identify early exercises and track repurchases. That means companies have to track liabilities linked to early exercises manually on a spreadsheet, which can be burdensome if the options vest on a monthly schedule. In a more complex case, tranche-level tracking is required for options that are partially early exercised.

Expense Treatment

Exercising options earlier than the vesting date doesn’t mean the required service period has been satisfied. Neither does it mean the employee has full ownership of the shares. According to ASC 718-10-55-31,

Under some share option arrangements, an option holder may exercise an option prior to vesting (usually to obtain a specific tax treatment); however, such arrangements generally require that any shares received upon exercise be returned to the entity (with or without a return of the exercise price to the holder) if the vesting conditions are not satisfied. Such an exercise is not substantive for accounting purposes.

As noted above, early exercised options are fully forfeitable and subject to repurchase. Therefore, the compensation expense of an award associated with an early exercise should still be recorded over its vesting period, which in ASC 718 is referred to as the requisite service period. If the vesting condition isn’t satisfied and a repurchase is effectuated, this is the trigger event for recognizing a forfeiture and reversing previously recorded expense.

Keep in mind that even though repurchasing the early exercised shares upon termination is common, this feature is a company right but 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 improbable-to-probable modification. That’s because the choice to not repurchase in effect allows the employee to retain shares that otherwise would have been surrendered via forfeiture.

The accounting treatment for a Type III modification requires a revaluation of the shares on the modification date, and then the expense would be accelerated immediately given no further service is required. (For more on Type III modifications, see the Equity Methods Modifications White Paper.)

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.

Many equity administration systems are not set up to handle DTLs, only DTAs that arise in the ordinary course of recording compensation expense without an 83(b) election. As the tax accounting gets scrutinized more closely leading up to an IPO, this is an important element of early exercise accounting to sort out.

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, special attention should be paid to the computation of hypothetical exercise proceeds for these awards. 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 (remember, ASU 2016-09 eliminated inclusion of the estimated tax benefit).

We’ve seen some companies inadvertently include early exercised shares subject to repurchase in basic EPS. This isn’t correct because the shares aren’t considered outstanding until the vesting conditions have been satisfied. Upon vesting, early exercised shares are then considered outstanding for basic EPS reporting purposes.

What if the shares subject to repurchase contain non-forfeitable rights to dividends (or equivalents)? In that case, they’re treated as participating securities subject to the two-class method for the presentation of EPS. (For more on participating securities and the two-class method, see the Equity Methods EPS White Paper.)

Disclosure Treatment

Unvested early exercised shares are considered outstanding for footnote disclosure purposes until one of two requirements are 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.

In short, the early exercised shares will be included in the beginning outstanding shares of the standard ASC 718 disclosure 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 (since they become basic common shares alongside all other common equity holders). 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.

In these cases, it’s necessary to set up a process to separately track early exercises and their vesting to properly disclose share roll-forward activities.

Proxy Reporting

Awards associated with early exercise activity need special treatment for the proxy tables. Returning to Section 8, Item 402(g), the SEC says that early exercised shares that are repurchasable shouldn’t be included in the Option Exercises and Stock Vested Table. Why? 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.

In certain circumstances, the company may decline to repurchase the unvested shares even if the employee fails to meet the service requirement after early exercises. As we mentioned, that triggers a Type III modification and the remaining unvested shares will be accelerated immediately. Since no further service is required, the shares are earned and should be reported in the Option Exercises and Stock Vested Table. Additionally, the incremental cost resulted from the Type III modification should be included in the Summary Compensation Table and Grants of Plan-Based Awards Table. (See the Equity Methods Modifications FAQ for more on how modifications affect the proxy.)

Parting Thoughts

Pre-IPO 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 upon going public. 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.

Even though the early exercise feature may no longer be offered after companies become public, the early exercises administration and reporting requirements won’t go away until the early exercised options vest. We’ve helped many companies incorporate early exercises in their automated reporting solutions. If you have any questions or need any assistance, please don’t hesitate to contact us.