Options and restricted stock cost the company nothing in cash, but under GAAP they are compensation. Leaving them out of the books is one of the most common first-audit adjustments, and it understates the real cost of the team in every margin and burn analysis.
The basic model
Under ASC 718, an award to an employee is measured at its grant-date fair value and recognized as expense over the requisite service period, usually the vesting period. The expense lands in the department of the person who holds the award: R&D, sales, marketing, G&A or cost of revenue.
Valuing options
Most startups use the Black-Scholes model. The inputs:
| Input | Typical private-company source |
|---|---|
| Fair value of the common stock | The most recent 409A valuation (nonpublic companies may use a valuation performed consistent with Section 409A as a practical expedient) |
| Exercise price | Per the grant, usually equal to the 409A value |
| Expected term | Often the simplified method: midpoint of vesting and contractual term |
| Volatility | Peer group of comparable public companies |
| Risk-free rate | U.S. Treasury yield matching the expected term |
| Dividend yield | Usually zero |
A worked example
On January 1, an engineer receives 40,000 options with four-year vesting and a one-year cliff. Black-Scholes gives a fair value of $1.20 per option.
- Total grant-date fair value: 40,000 × $1.20 = $48,000
- Straight-line expense: $1,000 a month for 48 months, recorded in R&D
- If the engineer leaves after 18 months, the expense for unvested options is reversed (or adjusted through the forfeiture estimate, depending on the policy election)
Policy elections
- Forfeitures: estimate them up front or account for them as they occur. Most startups account for them as they occur.
- Attribution for graded vesting: straight-line over the total period, or tranche by tranche. Straight-line is common for service-only awards.
- Expected term method for private companies.
Write each election into the stock compensation policy and apply it consistently.
What else to track
- Modifications, such as repricing or extended exercise windows, which can create additional expense
- Awards to non-employees, which are also measured under ASC 718
- Early-exercise arrangements, where cash received is a liability until the shares vest
- Restricted stock purchased by founders, where an 83(b) election affects the founder's tax, not the company's expense
The tax forms
When an employee exercises incentive stock options, the company furnishes Form 3921 to the employee by January 31 of the following year and files it with the IRS. Nonqualified option exercises by employees create wage income reported on Form W-2, with withholding.
Reporting
Board and investor reporting often shows stock compensation separately so readers can compare cash operating results. GAAP statements still include it in each expense line.
We maintain the grant listing with your cap table provider, calculate the expense each month, and prepare the Forms 3921 at year end.
Sources
- FASB Accounting Standards Codification, Topic 718, Compensation: Stock Compensation
- 26 CFR §1.409A-1 (eCFR)
- IRS, About Form 3921
- 26 U.S.C. §83, Property transferred in connection with performance of services (Cornell LII)
Questions founders ask
Do private companies have to expense stock options?
Yes. GAAP requires share-based payments to employees to be measured at fair value and recognized as compensation cost over the service period, whether the company is public or private.
Is stock compensation deductible for tax?
Timing differs from the books. For nonqualified options the deduction generally arises when the employee recognizes income, usually at exercise. Incentive stock options generally produce no deduction unless there is a disqualifying disposition.
