Share Options and the Cap Table: The Balance Sheet Item Growth Businesses Get Wrong

Share options are one of the few areas where a decision made by the board in fifteen minutes creates a technical accounting problem that lasts for years. In growth-stage and PE-backed businesses they are also almost universal.

The accounting is not optional and it is not a disclosure-only matter. Equity-settled share-based payments create a charge in the income statement whether or not any cash moves and whether or not the options are ever exercised.

What triggers the accounting

Any award of equity instruments in exchange for goods or services falls within scope. That includes employee option schemes, growth shares, warrants issued to advisers and shares issued to consultants in lieu of fees.

The charge is based on the fair value of the instrument at grant date, spread over the vesting period, adjusted for the number of awards expected to vest. Fair value at grant date is not the same as the exercise price, and it is not the same as the tax valuation agreed for scheme purposes.

The three inputs auditors challenge

Grant date fair value. For options over unlisted shares this requires a valuation model, usually Black-Scholes or a binomial model, with inputs for share price, exercise price, expected life, volatility, risk-free rate and dividend yield. Volatility for a private company is normally derived from listed comparators, and the choice of comparators needs a rationale.

Vesting conditions. Service conditions and non-market performance conditions are handled through the estimate of awards expected to vest. Market conditions are built into the grant date fair value and never trued up. Confusing the two produces a misstatement that recurs every year until someone notices.

Leaver assumptions. The expected forfeiture rate must be estimated and revisited each period. An assumption of zero forfeitures in a business with normal staff turnover will be challenged.

Cap table hygiene

Behind the accounting sits a more basic problem. Many growth businesses cannot produce a single authoritative cap table that reconciles to the statutory registers, the option agreements and the accounts.

Maintain one source of truth showing every class of share, every holder, every option grant with grant date, exercise price, vesting schedule and status, every exercise and every lapse. Reconcile it to Companies House filings and to the share-based payment charge quarterly.

This matters beyond the audit. In a transaction, cap table discrepancies are found during legal due diligence, and they delay completion at exactly the point where delay is most expensive.

The file to prepare

Before fieldwork, assemble the option agreements and board minutes approving each grant, the valuation model with inputs and the rationale for each input, the schedule of grants with vesting profiles, the movement table for the period showing granted, exercised, lapsed and outstanding, the charge calculation reconciling to the income statement, and the reconciled cap table.

That pack answers nearly every question an auditor will ask on this area, and it takes a day to prepare when the underlying records are in order.