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.

An outsourced CFO called me the other day. He said he’d heard about how easy it was do to FAS 123R equity compensation accounting in Corporate Focus—and he was anxious to get started. His high-tech client was actually being sold or refinanced the following week, and he needed to provide updated financial statements in accordance with GAAP. Because the company had not been tracking its equity compensation expense over the past few years, this involved updating the compensation line items.

This tech company had originally been using its law firm—one of the top West Coast firms—to track its stockholder records. Later, when the stock option plan was created and the company still had fewer than 50 employees, the law firm continued to track the option grants, vesting schedules and employee terminations using Corporate Focus, based on information provided by the company or based on the board minutes prepared by the law firm. 

At first, I happily told the CFO that accomplishing his goal was simple—he could just log into Corporate Focus and update the valuation and amortization variables that had not been tracked by the law firm, such as volatility, interest rate, and forfeiture rate. Once the variables were updated for each batch of option grants, he could then calculate how much equity-related expense needed to be included in the income statement for each annual reporting period, because the financial statements were being recreated anyway.

However, when I looked up the law firm in our tech support system, two things became apparent: a) they were an older customer and had not yet transitioned to our hosted platform for Corporate Focus; and b) they hadn’t updated their software in over a year and were about three releases behind. Without the latest updates, the equity accounting calculations would not be the most current, meaning that the CFO would not be able to take advantage of the system’s robust equity accounting features.

When I explained this to the CFO, there was an uncomfortable lull in our conversation. He was shocked and frustrated to discover that his client’s law firm was so many versions behind in Corporate Focus—and that they would not be able to schedule an upgrade on their internal systems for at least a week. Because the transaction had to be completed in the next seven days, there was just no time to spare. 

At that point, the CFO’s only option was to have the firm's paralegal provide their client’s information in the form of Excel spreadsheets. He would then have to manually move the data over to internal spreadsheets which he used for their other clients. Lastly, he would have to wade through the tedious process of determining the valuation for each grant and then the amount to expense for each reporting period. 

Unfortunately for the CFO and his client, walking through the necessary calculations would take about 30 hours of work over the next seven days—instead of just a few hours if he could have used Corporate Focus to do them. The end result was a huge waste of time, not to mention the additional legal fees related to sending all of the data to the outsourced CFO—and then of course the additional accounting fees to do the actual work. In 20/20 hindsight, this all could have been easily avoided had the law firm kept its software up-to-date or if the firm had been using Two Step's hosted platform. In either case, the client’s CFO would have been able to log in and execute his FAS 123R calculations in no time at all.

Law firms can easily avoid finding themselves in this undesirable situation if they regularly upgrade their systems or move to their software provider's hosted platform, which is always on the latest release. 

Will your firm be ready the next time a client calls with a request? If you’re unsure of the answer, you need to check out Corporate Hygiene: It's Like Brushing Your Teeth, But With a Different Kind of Payoff. This real-life story is a superb illustration of how intelligently managing your client data can go a long way in making a positive and lasting impression—with existing clients, potential clients and others who really matter.