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Publication date: 30 Sep 2021
us Stock-based compensation guide 2.5
In order to motivate and retain employees, companies typically require that employees fulfill certain conditions to earn and retain stock-based compensation awards. These are commonly called vesting conditions. An award is considered vested when an employee's right to receive or retain the award is no longer contingent on satisfying the vesting condition.
Exercisability refers to the date when an option may be exercised by the employee. In most cases, the vesting date and the exercisability date are the same. However, option plans sometimes specify conditions in which vesting occurs before the employee is allowed to exercise the option. In that case, an employee who is vested will be able to retain the option after termination of employment even though it cannot be exercised until some future date. Compensation cost is generally recognized from the grant date through the vesting date, but exercisability provisions may affect the expected term assumption and therefore, fair value. See SC 9.3.
While most stock-based compensation awards contain time-based vesting conditions, the terms of some awards contain provisions specifying that vesting, exercisability, or some other factor (e.g., the exercise price) depends on the achievement of an established target, as described in SC 2.5.2 and SC 2.5.3.
2.5.1 Definitions of vesting conditionsfor stock-based awards
ASC 718 defines three types of vesting conditions:
- Market condition
- Performance condition
- Service condition
The accounting for an award will depend on which conditions are included in the award's terms. If the award is indexed to a factor other than a market, performance, or service condition, ASC 718-10-25-13 requires the award to be classified as a liability. In some circ*mstances, awards could have multiple conditions (see SC 2.5.4). Figure SC 2-1 defines and provides examples of each condition.
Figure SC 2-1
Types of vesting/exercisability conditions
Market condition | Performance condition | Service condition | |
Definition [Excerpted from ASC 718-10-20, as updated by ASU 2018-07] | A condition affecting the exercise price, exercisability, or other pertinent factors used in determining the fair value of an award under a share-based payment arrangement that relates to the achievement of (a) a specified price of the issuer’s shares or a specified amount of intrinsic value indexed solely to the issuer’s shares or (b) a specified price of the issuer’s shares in terms of a similar (or index of similar) equity security (securities). | A condition affecting the vesting, exercisability, exercise price, or other pertinent factors used in determining the fair value of an award that relates to both (a) rendering service or delivering goods for a specified (either explicitly or implicitly) period of time and (b) achieving a specified performance target that is defined solely by reference to the grantor’s own operations (or activities) or by reference to the grantee’s performance related to the grantor’s own operations (or activities). A performance target also may be defined by reference to the same performance measure of another entity or group of entities. | A condition affecting the vesting, exercisability, exercise price, or other pertinent factors used in determining the fair value of an award that depends solely on an employee rendering service to the employer for the requisite service period or a nonemployee delivering goods or rendering services to the grantor over a vesting period. A condition that results in the acceleration of vesting in the event of a grantee’s death, disability, or termination without cause is a service condition. |
Examples | A stock option that becomes exercisable when the underlying stock price exceeds the exercise price by a specified amount (e.g., $10 above the exercise price). | Award that vests if a sales target of $3 million is achieved.Award that vests as a result of achievement of a defined EPS target. | Award that vests if the employee provides three years of service. |
Award for which vesting depends on the movement of the underlying stock or total shareholder return (TSR) relative to a market index of peer companies. Award that vests based upon a specified rate of return to a controlling shareholder (e.g., internal rate of return, multiple of invested capital). An award that vests when the company achieves a specified market capitalization. | Award that vests as a result of an initial public offering, some other financing event, a change in control, or the company's achieving a specified growth rate in its return on assets. | Award that vests upon an employee's death, disability, or termination without cause. |
2.5.2 Market conditionsof stock-based compensation awards
An award with a market condition is accounted for and measured differently from an award that has a performance or service condition. The effect of a market condition is reflected in the award's fair value on the grant date (e.g., using an advanced option-pricing model, such as a lattice model). That fair value will be lower than the fair value of an identical award that has only a service or performance condition because the effect of the market condition results in a discount relative to the fair value of an award without a market condition. All compensation cost for an award that has a market condition should be recognized if the requisite service period is fulfilled, even if the market condition is never satisfied (i.e., even if the award never vests). This is because the likelihood of achieving the market condition is incorporated into the fair value of the award.
2.5.3 Performance and service conditions that affect vesting
For an award with a performance and/or service condition that affects vesting, the performance and/or service condition is not considered in determining the award's fair value on the grant date. For companies that elect to estimate forfeitures(see SC 2.7.1), service conditions should be considered when a company is estimating the quantity of awards that will vest (i.e., the pre-vesting forfeiture assumption). Compensation cost will reflect the number of awards that are expected to vest and will be adjusted to reflect those awards that do ultimately vest.
A company should recognize compensation cost for awards with performance conditions if and when the company concludes that it is probable that the performance condition will be achieved. ASC 718’s use of the term probable is consistent with that term’s use in ASC 450, Contingencies, which refers to an event that is likely to occur (ASC Master Glossary). If there are multiple potential outcomes of the performance conditions that can affect the quantity or terms (e.g., exercise price or contractual term) of an award, the company should calculate a grant-date fair value for each potential outcome, and recognize compensation cost based on the value associated with the probable outcome, consistent with ASC 718-10-30-15. A company should reassess the probability of vesting at each reporting period for awards with performance conditions and adjust compensation cost based on its probability assessment. A company should recognize a cumulative catch up adjustment for such changes in its probability assessment in subsequent reporting periods, using the grant date fair value of the award whose terms reflect the updated probable performance condition, consistent with the guidance in ASC 718-10-55-78 and ASC 718-10-55-79.
In certain situations, a company may not be able to determine that it is probable that a performance condition will be satisfied until the event occurs. For example, a company typically cannot conclude it is probable that a liquidity event, such as a change in control of the company, will occur until the date of consummation of the liquidity event because such an event isfundamental to the company's organizational structure, isoutside the company's control,and is subject to significant external contingencies with a high degree of uncertainty. Accounting for the related compensation expense at the time the event occurs is also consistent with the guidance in ASC 805-20-55-50 through ASC 805-20-55-51, which states that termination benefits triggered by the consummation of a business combination should be recognized when the business combination is consummated.
A distinction, however, should be made between the sale of an entire entity (i.e., a change in control) and the sale of a portion of an entity that is a business (e.g., a business unit). When considering probability for the sale of a business unit, the threshold for the sale is analyzed differently than for the sale of the entity. If the sale of a business unit were to meet the "held for sale" criteria of ASC 360, Property, Plant and Equipment, the sale may be considered probable because meeting the held-for-sale criteria creates the presumption that managementhas determined that sale of the business unit is probable.
Example SC 2-3 illustrates the accounting for awards with performance conditions.
EXAMPLE SC 2-3
Award with performance conditions
On January 1, 20X1, SC Corporation grants stock options to employees that vest in three tranches based on achieving a defined EBITDA target in each of the next three years (20X1, 20X2, and 20X3). The employees must also provide service for the entire three years to vest in the options. For example, the first tranche of options vests based on achieving a defined EBITDA target in 20X1 and the employees providing service through the end of 20X3. No employees are expected to terminate employment during the three-year period and SC Corporation estimates forfeitures.
As of the grant date, SC Corporation believes the 20X1 and 20X2 EBITDA targets are probable of achievement, but the EBITDA target for 20X3 is not.
How should SC Corporation account for the performance conditions?
Analysis
SC Corporation should measure the fair value of the awards at grant date without regard to the vesting condition and should recognize compensation cost for the awards that are expected to vest—i.e., the tranches with an EBITDA target that is probable of being achieved. In this example, SC Corporation should begin recognizing compensation cost for the first and second trancheson a straight-line basis over the three-year requisite service period(as the awards have cliff-vesting after three years). SC Corporation should reassess the probability of achieving the performance conditions at each reporting period and record a cumulative catch-up adjustment for any changes to its assessment (which could be either a reversal or increase in expense).
2.5.3.1 Performance conditions satisfied after the service period
Generally, an award with a performance condition also requires the employee to provide service for a period of time. The service period can either be explicitly stated in the award or implied such that the award is forfeited if employment is terminated prior to satisfying the performance condition. In some circ*mstances, however, an employee is entitled to vest in and retain an award regardless of whether the employee is employed on the date the performance target is achieved. In other words, the employee is not required to provide continued service through the satisfaction of the performance condition to retain the award.
An example is an award that vests if an employee provides four years of service and the company completes an IPO. In this example, the employee is not required to be employed at the date of the IPO. In other words, the employee could terminate his or her employment after four years, but still retain the right to vest in the award if the company completes an IPO at a later date prior to the expiration of the award.
Another example is an award with a performance condition granted to an employee who is eligible for retirement, when the award allows for continued vesting if the performance target is achieved post-retirement. As discussed in SC 2.6.7, in this fact pattern, the service period ends on the date the employee is eligible to retire because no further service is required to retain the award.
Performance targets that affect vesting and could be achieved after the service period should be accounted for similar to other performance conditions. Therefore, such a condition should not be reflected in estimating the fair value of the award on the grant date. Rather, compensation cost should be recognized over the requisite service period (i.e., only the period the employee must provide service) if it is probable that the performance target will be achieved.
In periods subsequent to the service period, compensation cost is adjusted if the probability assessment changes. For example, if during the service period, it is not probable the performance target will be achieved, no compensation cost is recognized. If after the service period is completed, it becomes probable that the target will be achieved, compensation cost should be recognized immediately.
Similar to other awards with performance conditions, entities should consider whether the condition is a substantive vesting condition. For example, if a mechanism exists for the employees to receive value from the award even if the performance target is never achieved (e.g., through rights to dividends or dividend equivalents, put or call rights, transferability provisions or other features), the condition may not be a substantive vesting condition. A condition that is not substantive does not affect recognition of compensation cost.
Example SC 2-4 illustrates the accounting for an award with a performance condition and an employer call right.
EXAMPLE SC 2-4
Award with performance condition and employer call right
SC Corporation grants stock options to certain top-level executives that are only exercisable after a triggering event, such as an IPO (performance condition). However, SC Corporation may call the option at the intrinsic value upon an employee's termination. If SC Corporation does not call the option, the individual can continue to hold the option post-termination through the original contractual term and exercise it if an IPO occurs during that time.
How should SC Corporation account for this award?
Analysis
Typically, the value of an award with a performance condition is recognized when it is probable of being achieved. A performance condition, such as a successful IPO, is generally not considered probable until it actually occurs. This would suggest that the expense for these awards would not be recognized until an IPO occurs. However, the existence of the company's call right upon termination of employment raises questions about whether the employee's right to receive value from the award or "vesting" is truly contingent upon the performance condition, or if, in substance, the award always provides value, either upon termination through the employer call right or upon the trigger event. While the employee has no rights to demand value from the company (i.e., it is not a put right), the employee will eventually terminate employment, which would trigger SC Corporation’s call right, and terminating employment is within the employee's control.
If SC Corporation's intention is to exercise the call feature and pay the departing employee for the awards (e.g., if SC Corporation does not want any former employees to hold shares and is willing to provide former employees with liquidity for their awards upon their departure), the award would be classified as a liability (as it is probable that SC Corporation will prevent the employee from bearing the risks and rewards associated with share ownership for a reasonable period of time) and it would in substance be fully vested upon grant. See SC 3.3.3 for further discussion.
If, however, SC Corporation does not intend to exercise the call feature and can support its intention not to exercise the call feature, then the grant date fair value of the award would be recognized only when the performance condition becomes probable, consistent with ASC 718-10-30-28. This would be appropriate if, for example, SC Corporation does not intend to exercise its call feature and is comfortable with former employees continuing to hold options. Award holders, whether they are employees or former employees, will only receive value upon an IPO, if one occurs during the contractual term of their award.
2.5.4 Performance and service conditions affecting other factors
For performance and service conditions that affect factors other than vesting (e.g., exercise price, number of shares, conversion ratio, or contractual term), companies should compute a grant-date fair value for each possible outcome on the grant date. For example, consider an award that has four different exercise prices based on whether an employee achieves one of four targeted sales thresholds. Each outcome would have a different grant-date fair value and the company should recognize compensation cost for the outcome that is probable. This probability assessment should be updated each reporting period and the company should record a cumulative catch-up adjustment for changes to the probability assessment. If a company concludes that none of the outcomes are probable, no compensation cost should be recognized until such time that an outcome becomes probable. The final measure of compensation cost should be based on the grant-date fair value for the outcome that actually occurs.
ASC 718 provides guidance on and examples of accounting for awards that have market, performance, and service conditions that affect factors other than vesting and exercisability (see ASC 718-10-55-64 through ASC 718-10-55-65 and Example 3, Example 4, and Example 6 in ASC 718-20-55-41 through ASC 718-20-55-67).
Figure SC 2-2 summarizes the key differences among all of the conditions, including certain awards with common multiple conditions, and their effect on fair value.
FigureSC2-2
Differencesamongconditionsandtheireffectonfairvalue
Condition | Effect on grant-date fair value | Effect on compensation cost |
Market condition affects vesting | Condition considered in the estimate of fair value on the grant date. | Compensation cost is not adjusted if the market condition is not met, so long as the requisite service is provided. |
Performance or service condition affect vesting | The performance or service conditions are not reflected in the estimate of fair value on the grant date. | Compensation cost is recognized only for the awards that ultimately vest. |
Performance and market condition affect vesting | If both conditions must be met for the award to vest, the market condition is reflected in the estimate of fair value on the grant date. | Compensation cost is adjusted depending on whether or not the performance condition is achieved. If the performance condition is met and the requisite service is provided, compensation cost is not adjusted even if the market condition is not achieved. |
Performance or market condition affects vesting | The fair value recognized depends on whether the performance condition is achieved. The performance condition would not be reflected in the estimate of the fair value, but the market condition would be. Both amounts should be calculated at the grant date. | Compensation cost is adjusted depending on whether or not the performance condition is achieved. If the performance condition is not probable of being achieved, then compensation cost for the value of the award incorporating the market condition is recognized, so long as the requisite service is provided. If the performance condition is probable or becomes probable of being achieved, the full fair value of the award (i.e., without regard for the market condition) would be recognized. |
Market condition affects something other than vesting | The market condition is reflected in the estimate of fair value on the grant date. | Compensation cost is not adjusted if the market condition is not met, so long as the requisite service is provided. |
Performance or service condition affect something other than vesting | The fair value on the grant date is determined for each potential outcome. | Compensation cost is based on the grant-date fair value of the award for which the outcome is achieved. |
Performance and market condition affect something other than vesting | The fair value on the grant date is determined for each potential outcome of the performance condition and the market condition is reflected in the estimate of fair value for each potential outcome. | Compensation cost is based on the grant-date fair value of the award for which the performance condition outcome is achieved and is not adjusted if the market condition is not met, as long as the performance condition is met. |
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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