Two Step's Private Company Equity Management Blog

As noted in my recent blog post FAS 123R: You Have to Crawl Before You Can Walk - Part 1, helping busy CFO's generate the disclosure requirements of FAS 123R (now ASC Topic 718) reminded me a little of watching my one year old learn to walk and the three step process described below. With the goal of creating the requisite financial statement disclosures, I'll now continue with Part 2 of the three steps a typical privately held, venture-backed company needs to understand for equity compensation reporting of plain vanilla option grants. In case you are more advanced, please note that this article addresses the basics of FAS 123R.

1. Part 1: Learn to Roll Over - Value the option grants
2. Part 2: Learn to Crawl - Expense the option grants
3. Part 3: Learn to Walk - Report the expense and related disclosures

Learn to Crawl - Expensing the Option Grant

In part 1 of this blog series, we reviewed how to generate the fair value of an option grant using the Black-Scholes calculation. That was the easy part. Now, we will use the fair value per share and amortize it over the requisite service period.

In order to understand how to amortize the fair value, you first need to understand the eight items listed below. Using them, you will choose an expensing method and amortize the fair value of the requisite service period. You will then use this amortization schedule to generate the expense for each reporting period. For each reporting period, you may also need to "true-up" the expense being reported, as described below. When expensing your options, keep in mind one of FASB's guiding principles: At any point in time, you must have expensed the pro rata portion of the fair value based on the portion of the option that has vested.

1. Fair Value Per Share: This is the value of the option calculated based on the Black-Scholes formula.
2. Actual Fair Value: Fair Value Per Share x Number Granted = Actual Fair Value. This value is the total amount we will expense for this option over its service period if the employee does not terminate before the option is fully vested.
3. Requisite Service Period: This is the time period over which you will expense the option grant. When dealing with plain vanilla option grants, this is based on the period the option vests. For example, if the option's vesting schedule is 25% per year for 4 years, the requisite service period for this option is 4 years.
4. Forfeiture Rate: This is a projected annual rate that you expect options to be forfeited in the future. Forfeited means options which are cancelled before they vest. It does not include options that expire, meaning options that are cancelled after they vest. This rate is used to discount the amount of the actual fair value that is expensed in each reporting period. Private companies with little or no historical employee forfeiture data may need to look to a comparable rate, such as the turnover rate at peer companies to determine a reasonable forfeiture rate (until you have your own sufficient historical data to use).
5. Reporting Period: This is the time period in which you will report your expense. For example, if the company reports annually and the fiscal year end is 12/31, the reporting period for 2009 is 1/1/2009 - 12/31/2009.
6. Expensing Method: You are able to calculate the amortization schedule for an option grant using one of the following three methods. Each of these methods use the forfeiture rate to discount (or "haircut") the Actual Fair Value.

1. Straight-Line: The straight-line expensing method is where you divide the projected fair value by the number of days in the requisite service period. Using this method expenses the same amount in each reporting period. The problem with using the straight-line method is that under many vesting schedules, you may not satisfy the requirement referred to above of expensing at least the portion of the fair value as the option has vested to date.
2. FIN 28 (Accelerated Method): The accelerated expensing method treats each vesting tranche as a separate amortization period from grant date to vest date. This results in the expense being front-loaded, since expense from each vesting period is taken in the current reporting period. Although this typically satisfies the FASB requirement referred to above of expensing at least the portion of the fair value as the option has vested to date, it can have what some companies consider the negative impact of a much greater expense being taken in earlier years and a much lower expense in later years.
3. Modified Straight-Line: The modified straight-line expensing method (which I recommend) is based on the straight-line expensing method, but adjusts for the requirement that you need to recognize at least the portion of the fair value as the option has vested to date. This results in a slightly higher expense in earlier periods, but ensures that you take enough expense under both graded and front-loaded option vesting schedules.
   
   Regardless of which method you use, if an option fully vests, you end up taking the same amount of expense over the entire service period.

7. Projected Fair Value: The actual amount expected to be expensed each period is called the Projected Fair Value which is the Actual Fair Value reduced by the forfeiture rate. This value is generated through the creation of the amortization schedule.
8. True-Up: At each reporting period, you can consider running a "true-up" of projected fair value based on actual forfeitures and actual vesting events. When adjusting for a true-up using the modified straight-line method, you recalculate the amortization schedule to determine how much should be expensed at the end of that reporting period. This adjustment results in:

1. A credit entry for any expense taken for any options forfeited during the reporting period (options cancelled prior to vesting).
2. A debit entry for any employees still with the company to account for (a) the amount that actually vested during the reporting period and (b) a portion of the next vesting tranche that is more likely to vest.

If you determined a reasonably accurate projected forfeiture rate, the true-up amount should typically be immaterial. If it is not, you should consider adjusting the forfeiture rate you use going forward. Also, keep in mind that when an option fully vests, you end up expensing the actual fair value for that grant regardless of the forfeiture rate you selected.

Just like when my one year old first started to crawl, it takes some assistance and a little trial and error before you understand how to generate an option's amortization schedule. It is a complicated process and this short article is only able to provide an overview of the basics. The complexity in the process is the reason that so many companies turn to a more automated system that involves less management and manipulation of complex spreadsheets.

To see how an integrated equity management system can bring together stock plan administration, FAS 123R reporting, and equity compliance, sign up for a demonstration of Two Step Software's online equity management system, Equity Focus.

If you have not yet read Part 1 on valuation, you may find it helpful. Otherwise, Part 3 will be posted shortly that discusses how to generate the financial statement disclosures of FAS 123R.

If you have any questions, feel free to contact me at jwright@twostep.com or post them in the comments below. If there are any areas where you would like more information, please let me know.

Corporations depend on their CFOs to report "the numbers" each period. But what happens when these numbers are based on data that’s being tracked at the company's law firm—instead of internally? 

When a company is initially formed, all of the legal and ownership records tend to be maintained by their law firm because, frankly, it's just easier. Over time, the organization begins to grow, and as it does, the complexity of its capital structure tends to grow as well. For example, as an enterprise gets its first round of angel or venture capital financing, it may issue convertible preferred stock and warrants and adopt an employee stock option plan.

The complexity typically relates to the company's capitalization table, its stock plan administration, and the reporting of equity compensation expense under FAS 123R. Each year or quarter, the CFO must determine—in addition to how much was paid in cash compensation and benefits to the company's employees—how much compensation was paid to employees who have stock options or other equity compensation.

The Current Approach No Longer Makes Sense

Although stock plan administration work can be outsourced by a company to its law firm, the equity compensation reporting normally isn’t, because it involves accounting work. And so, at the end of each year, it has been common practice for paralegals to send reports and spreadsheets to CFO clients who need to calculate their stock option related expense. The CFOs then take the information provided, add it to their own internal spreadsheets, and run the numbers for the period.

The problem? This typical approach has proven to be very difficult, time-consuming, and error-prone. The challenge is that the data is being updated by the law firm while the accounting calculation that uses the data is being done by the company—each in their own separate system or set of spreadsheets. An uncoordinated system and a virtual recipe for disaster.

The Solution? One Consolidated System.

The solution is to bring the stock plan administration being done by the law firm and the equity compensation reporting being done by the CFO together seamlessly in a single, consolidated system. In this way, everyone is using the same set of live data and the information is real-time, accurate, and consistent. No time is wasted sending reports and spreadsheets back and forth while manually updating information that is being tracked and reported by one side or the other.

Here’s how this integrated approach works: At audit time, the CFO logs into the stock plan administration and equity compensation reporting system that has been used by the paralegal at the law firm throughout the year. The CFO knows that all required changes for the year have been updated, since he or she has had access to the information all year and has updated the valuation variables on an ongoing basis. 

To calculate the amount of equity compensation expense for the current period, the CFO simply presses a button or opens a report. Because the same formulas are used consistently throughout the system for every record and across each period for the expense calculation, as well as for the required financial statement disclosures, the CFO can be confident that it is 100% accurate.

Whether the consolidated system is at the law firm, at the client’s office, or somewhere in between is immaterial. What’s important is that everyone is using the same system. All parties can log in and work on the areas that are relevant to them, and everyone can see the data live and report on the information as their needs require. 

A single system for stock plan administration and equity compensation reporting ensures that data is reviewed and kept up-to-date over the course of the reporting period. And because all of the information is already in the system well before the end of the reporting period, it avoids the typical mad rush at audit time. 

Does this sound like a better method? It is. Does it sound too easy to be true? It's not. Many law firms and CFOs are already using this approach—and they're thrilled with the results. What a difference it can make at audit time (not to mention everybody’s stress levels). It's just a matter of working together.

In a recent issue of the popular newsletter Softletter, Edward Pratesi, CPA of Brentmore Advisors, LLC, does an outstanding job in the article entitled: “Valuing Options While Running the Compliance Gauntlet "explaining the complicated interplay between FAS 123R and Sec. 409A in the context of determining the fair market value for privately-held companies of the common stock underlying an employee stock option. This is a critical input for qualified stock options where the option must be issued with a strike price equal to fair market value on the date of grant to comply with IRS Sec. 422 and can’t be issued at a discount if you want to avoid the penalties under Sec. 409A.

Pratesi explains the background behind both 123R and 409A and then articulates the valuation standards under each section and how they differ. As he articulates it:

It is important to note again the difference between FASB 123R And IRC Section 409A as they appear to be similar but approach the valuation of options and securities from different perspectives. FASB123R concerns stock option valuations for financial reporting purposes and is measured using the issuing company’s perspective … IRC 409A is concerned with the issuance of stock based compensation … The objectives to ensure that the securities being granted … are granted at fair market value … Under either regimen, the value of the underlying security – the common stock – is critical in determining the value of the stock option.

He later explains that the inherent difference is that FAS 123R uses a “fair value” standard and looks to the AICPA practice aid “Valuation of Privately-Held Company Equity Securities Issued as Compensation.”Sec. 409A uses a “fair market value” standard and offers three safe harbors for valuation: a) the binding formula presumption; b) the independent appraisal presumption; and c) the illiquid start-up presumption. If the valuation satisfies one of these safe-harbor presumptions, then it is assumed to be “reasonable” for 409A purposes and the burden shifts to the IRS to prove that the valuation was not “a reasonable application of a reasonable valuation method.”

In the latter part of the two part article, the author offers a set of questions and answers that many companies will come across as they deal with valuation for the first time. A few of the highlights are:

Question: Which one of the above standards will impact us the most?

Answer: Since most privately-held technology based companies will be issuing stock options (and in many cases more than once a year), anticipate that a valuation of the underlying stock will be needed to meet IRS standards first and the financial reporting requirements under 123Rsecond.

Question: If both the FASB and IRS require that our privately-held company be valued, can we have one valuation report prepared to meet both standards?

Answer: Maybe.

I have read dozens of articles on this issue over the past one to two years and strongly feel that for the CFO or stock plan administrator who is not a valuation expert, but needs to know just enough to be able to talk intelligently when considering the various options for common stock valuation in the context of equity compensation reporting, this article is a diamond in the rough and for that reason appreciate the publisher of Softletter making this article available to the public.

When I got a pop-up message from Intuit the other day that they have jumped on the bandwagon and released a read-only version of QuickBooks Online for the iPhone, it got me thinking about cell phones and my new iPhone. It made me realize how pervasive this new productivity tool had become in the nine months since its release. It’s particularly noteworthy, since QuickBooks Online does not yet work with the Apple Safari browser. Although it’s very limited and many will ask was it really worth the effort, I think it’s a great looking view-only application and delivers a minimum amount of information into the palm of your hand. How much is in a bank account? How much do we owe that vendor? How much does this customer owe us today? A balance sheet for Dec.31st? It’s all there.

But I wondered, are they perhaps just trying to get on the “Mac is cool” bandwagon after seeing the recent onslaught of the square guy v. the cool guy in the Apple v. PC television commercials (http://www.apple.com/getamac/ads/) or have they seen the genuine utility for their user base of a “less is more” iPhone approach to online apps (http://www.apple.com/webapps/).

My own mobile, wireless experience has been that of frequently switching to the latest and greatest cell phone (sometimes I admit more than once a year) until I’ve finally settled down … with an iPhone and "it rocks.” At first, a flip phone seamed so cool compared to the original peanut shaped phones. Then, along came the Razr which was so thin, who could resist. Then, I had to debate a Blackberry versus the Treo when they were still head to head in popularity. I chose the Treo700w, since I wanted to remain in the Windows family, but learned to regret the choice.

Then, last summer, one of my neighbors was showing me travel photos on his iPhone, “finger flipping” from one picture to another and the totally useless, but cool looking, world clock for the cities he had traveled to. The user experience was contagious, almost like bubonic plague or methamphetamines. I had to have one.  BUT, I had to worry about the ATT Wireless Edge network. Everyone claimed it would be like going back to 1998 dial-up for web surfing. Well, I decided I’d just limit my browsing to Wifi access, since by 2007 carrying around a cell phone and an iPod on a bike ride or on an airplane seemed so old-fashioned. Two devices? I thought if over one million iPhones had already been sold by Sept. 2007, why not be 1,000,001. Certainly, no one could claim I was the first guy to jump off the bridge.

Six months later, there are over 5 million iPhones in use. In fact, every employee at Two Step Software has been offered an iPhone just so they can experience the direction of new technology (Apple has certainly led on innovation from the original Macintosh to today’s iPod Shuffle - now that’s small). If you’re working at a SaaS model software company on America’s Technology Highway (Route 128), spitting distance from MIT, it’s somewhat obscene to still be carrying around a cell phone, a Palm pilot, an iPod, and a beeper. Get it together!

At the rate that iPhone applications are coming out, it’s becoming the ubiquitous connectivity device for the new business executive, less focused primarily on email and more focused on browsing and other online productivity applications. I use my iPhone for phone calls, emails, text messaging, listening to music, checking the weather, reading NY Times headlines, contact management, scheduling, family photos, my alarm clock, maps and directions, YouTube, secure password management, Salesforce.com, and QuickBooks.

If you too want to be the coolest over 40, Facebook, MySpace, YouTube, Twitter, Blogspot, Gen X, SaaS, on-demand, CFO or CPA and "connect” with those young, hipster 20-something employees slugging down Jolt and cranking out Ajax code, get an iPhone, download a Wagner symphony, and surf the Wall Street Journal Online. They’ll see you rocking out and think you’re watching Sarah Silverman F------ Matt Damon on YouTube (http://www.youtube.com/watch?v=wnVJZkDuVBM).

Now, that’s cool.