Two Step's Private Company Equity Management Blog

I'd like to share with our Corporate Focus and Equity Focus users three great resources that I recommend for equity planning, equity transactions, and understanding equity instruments. Our customers have used all of these, and I want to make sure the Two Step community is aware of them. This is Part 2 of a three-part series.

If you're looking to create a virtual deal room for your next equity transaction, you'll want to check out Firmex: www.firmex.com. This is a SaaS deal room application that has been used by many of our law firm customers for transactions of all sizes. Firmex features a unique "all you can eat" pricing model that allows you an unlimited number of deal rooms. If you're a law firm with a lot of clients that do equity or M&A transactions, Firmex can be very attractive - and even better, your ROI increases the more you use it. You can even private-label the application to reflect the branding of your firm's website.

The Firmex website says:

"With its virtual data room solutions, Firmex helps organizations securely share confidential information and collaborate online. Since 2006, Firmex has been licensing its on-demand virtual data room technology for corporate transactions, contract management, litigation, governance and compliance. Firmex focuses on delivering highly secure, reliable, fast and intuitive document-sharing technology with top-tier, 24/7/365 support and security."

When comparing the tool to other options, one Firmex law firm client says: "Firmex allows us to provide a valuable service to our clients at a significantly lower price than other third-party providers. The features, functionality and reliability of Firmex rival or exceed other providers and the customer service is excellent."

If you're doing equity transactions of any type and need a virtual deal room, take a look at Firmex. They'll get you up and running fast - and help you make a winning impression on your clients.

And here's more good news: with the export feature in Corporate Focus, it's easier than ever to move large collections of entity, ownership, governance and compliance documents from Corporate Focus to Firmex and meet the tight deadlines of your next due diligence request.

I'm often asked this question by lawyers interested in using Corporate Focus to improve equity management and corporate compliance tracking for their clients: When is the right time to start? Are we too early? Are we too late? Are we right on time?

To help answer these questions, I'd like to tell you about three very different law firms I met with just this past week.

The Small Firm: The first one is a sole practitioner who just left the largest law firm in the world a few months ago; he had used Corporate Focus for his client tracking for several years. This lawyer only has 5-10 clients to put in the system, but these clients represent the vast majority of his revenues. He wants to give them outstanding value for every dollar billed. And he knows that direct access to their data will impress them--and make them feel like they're still getting the same top-notch service they enjoyed at the mega-firm where he previously worked.

The Big Firm: The second is the largest law firm in one Northeastern state where they have over 1,000 corporate minute books they've been tracking for their clients for years. This firm would love to be more efficient when they do their client work--and they'd like to provide clients with direct access to their information. However, with so many minute books (and about 5-10 people that would be forced to change the way they track their clients' data), the project seems a bit overwhelming. They're not quite sure how to get started. They had looked at getting Corporate Focus a few years ago, but decided to postpone it until a "better time" rolled around. At the same time, this prestigious firm wouldn't like their clients to know that their paralegal goes through a mad scramble to calculate ownership information and even to locate minute book documents.

The Medium Firm: The third firm has about 50 attorneys, is the leading business law firm in an exciting region of the West coast, and tracks about 200 client minute books. One of the paralegals present at my meeting was working on a closing recently and the paralegal on the other side of the table asked her colleague how she printed the 45 stock certificates. After hearing the groan from the first paralegal, the other recommended Corporate Focus and said she can print 45 stock certificates in less than 15 minutes without any errors. The first paralegal brightened instantly and she got approval to get started with Corporate Focus in the next few weeks.

Should You Standardize Now?

Imagine if you were an attorney at any one of these law firms. Do you think you should get Corporate Focus now--or later? What if you were a paralegal working for one of these firms? Or a client?

I frequently talk with lawyers who clearly see the value of Corporate Focus for their work and their clients, but they're just not sure if it's the "right time" to get it up and running. There's no question that moving to a consolidated online system for equity management and corporate compliance tracking will change the way you currently work. But change is often a good thing. Efficiency is critical when you are providing high-value services at high billing rates--and you don't want to waste any time on low-value work.

Take a look at the real-life examples above. Maybe they will help you decide if it makes sense for your firm to use a streamlined, centralized online system to better manage your clients' critical information.

If you're still not sure, ask yourself the question:

What would our clients and staff want us to do?

Over the past 15 years, we've helped hundreds of law firms make the move to a more efficient, accurate and collaborative way of working. We'd love to help yours get there, too.

How Corporate Focus Can Make Your Life Easier: Check out this list of 10 key problems that are quickly solved by Corporate Focus:

http://www.twostep.com/CFsolveproblems

As the founder of Two Step Software, I've been asked numerous times how to simplify the many complex aspects of equity management. When we developed our online system 15 years ago, our goal was to use a database application to make the equity management and reporting process easier, faster and more accurate. And as we continue to work with new customers and listen to their challenges, we often come back to the same three-part framework that can be used create a solid foundation for anyone involved in this type of work. The basic framework consists of the following:

1. Capitalization
2. Equity Accounting
3. Compliance and Documentation

Now, let's take a brief look at each of these areas individually.

A. Capitalization

Capitalization means tracking who owns the company and what they each own. The capital structure may consist of many different types of ownership instruments, such as common stock, preferred stock, options, warrants, restricted stock, and convertible notes. Each equity instrument is held by different types of owners, such as founders, management, employees, investors, lenders, and partners.

The three basic components of capitalization tracking are:

1. Stock plan administration: The basic tracking of each type of ownership instrument and who owns it.
2. Equity transactions: Ownership changes occur over time for many reasons such as initial issuances or grants, transfers, vesting, exercises, employee terminations, restrictions lapsing, death, and divorce.
3. Fully-diluted capitalization tables: There are many ways to report the capitalization of a company, but there are a few common formats which generally are based on types of ownership or who the owners are (by person or group). A common way to report the total ownership of a company is to look across all of the different types of ownership and break it down to the simplest level which is known as "common equivalents."

Ownership record tracking is the foundation for accurate equity management. If it’s not 100% correct, any errors or inconsistencies will lead to costly mistakes that will get magnified over time.

B. Equity Accounting

Equity accounting is an exercise to determine what number should be reported for equity compensation expense in the income statement for the period. Until FAS 123R (which came about in Dec. 2004), many venture-backed, non-public companies typically reported no equity compensation expense for stock options granted at fair market value. Under FAS 123R, this is no longer permitted. Now, privately-held companies that report in accordance with GAAP or are being audited must include an equity compensation expense amount, even for ISOs.

The three basic components of equity accounting are (using the example of stock options):

1. Valuation: FAS 123R requires a company to determine the "fair value" of a stock option granted to an employee using an accepted valuation formula such as Black-Scholes. Its variables include: exercise price, FMV, expected term, volatility, risk-free interest rate, and dividend rate.
2. Expense determination: FAS 123R mandates that a company recognize the cost of equity-based compensation over the related "service period" (usually the vesting period). It also requires the use of an expected forfeiture rate and periodic "true-ups" to account for the fact that a portion of options may never vest.
3. Financial statement disclosures: Paragraphs 64, 65, and A240 of FAS 123R describe the disclosure objectives and minimum disclosure requirements. Examples of these disclosures include: range of variables used for calculating fair value; weighted-average values for fair value, exercise prices, and remaining term; options exercisable at the end of the period; and unvested options at the end of the period.

C. Compliance and Documentation

Too many companies fail to think about good compliance and documentation in advance. Instead, they wait until someone needs something they can't find—and that’s usually the auditor as the audit is being wrapped up or an attorney doing due diligence for an important transaction.

The three basic components of compliance and documentation are:

1. Legal compliance: Every time equity is given out, it involves a legal process, such as memos to the compensation or option committee, board or committee votes, delivering option grants and stock certificates, and notices to employees. Many of these tasks can be performed by someone in legal or finance, but the process should be established ahead of time and documented with legal sign-off.
2. Legal documentation: On the legal side, you need to track copies of each legal action, legal notice, or agreement. These documents should be tracked in the system that you are using for equity management with documents linked to the corresponding records.
3. Accounting documentation: On the accounting side, your system should be able to track and report how each number was determined and any supporting documents. This could involve reconciliation of options outstanding, exercised or vested; variables used in the Black-Scholes formula; or amounts expensed in each period. When an auditor wants to see the backup detail, it should be easy to pull from the system, avoiding extra effort and wasted time.

Fit the Pieces Together and Save (Time and Money)

To be successful at equity management, you must fit all the pieces of the puzzle together. You can't leave out one piece or ignore its importance. Do it right and you’ll drive down one of the high-cost areas of corporate accounting for any venture-backed company. Equity management and accounting can be expensive and time-consuming since it normally involves costly legal and audit resources.

Optimizing these three aspects of your equity management means bringing all of the information and tracking into a single, consolidated system that the entire team—across finance, legal and audit—can use for their particular requirements. When you do, you can finally get rid of all those complicated spreadsheets and get your work done faster and better than you ever thought possible.

Download our FAS 123R Productivity Kit to find out how to simplify your equity management and FAS 123R reporting.

On my way to the International Legal Technology Association's 2009 conference, I read the Wall Street Journal's front-page article, "Billable Hour Under Attack - In Recession, Companies Push Law Firms for Flat-Fee Contracts," with great interest. The initial talk about a change in the ways law firms bill their clients came as the financial markets were on the brink of collapse. Now, almost 12 months later, the evidence shows that there is a real shift taking place-and it may not be as temporary as the current economic downturn.

Some interesting facts from the WSJ article:

• Pfizer will save 15-20% on outside legal fees "largely through flat-fee arrangements"
• Cisco uses fixed fees or other alternatives to the billable hour for about 80% of its legal work
• American Express has not had any firm tell them they would not consider alternatives to the hourly billing model
• $13.1 billion has been spent on alternative billing arrangements so far this year, compared to $8.6 billion in the same period last year (BTI Consulting Group survey)
• Lawyers reported average cost savings of 15% from using alternative billing arrangements (BTI Consulting Group survey)
• 63% of the 370 in-house lawyers surveyed plan to increase their use of alternative billing arrangements (BTI Consulting Group survey)

With this type of compelling data supporting the use of alternative billing arrangements, it's clear that the tide has turned. Whenever appropriate, companies will be asking their outside counsel for billing options that align the interests of clients with those of their counsel. This is in stark contrast to the traditional hourly billing model which favors the law firm at the expense of the client.

Firms are Shifting Their Focus to Productivity

Pfizer's General Counsel, Amy Schulman, articulated the new legal billing mindset, stating that she did not want a discount on hourly fees, but a fundamental change "that will last beyond whatever people think they have to tolerate because of the economy." 

This change is pushing law firms to look for ways to work more efficiently since, unlike the hourly billing model, they will now have an incentive to get more work done in less time. As an example, the WSJ article says that Orrick, Herrington & Sutcliffe in San Francisco has tripled the revenue it generates from alternative billing arrangements "but has maintained profitability through efficiencies," according to their chief client-service officer, David Fries. How do they do it?  Among other things, the firm employs workflow technologies that substantially increase productivity. 

Now, this is not rocket science. Aren't these essentially the same types of productivity enhancements that have become standard practice at most businesses (that aren't working by the hour)? Implementing technologies that help you get your work done faster and better simply makes good business sense.

In working with hundreds of corporate law firms over the past 15 years, we at Two Step Software have seen remarkable productivity improvements in the more routine areas of business law, such as:

• Calculating capitalization tables and managing ownership information
• Searching for minute book records and historical filings
• Creating documents, stock certificates and standard forms
• Tracking compliance information and generating alerts
• Sharing information and documents with clients

One example is our Corporate Focus customer Macfarlane, Ferguson & McMullen which is now "able to complete an organization from start to finish within 30-45 minutes" instead of the time it used to take to complete the process. The attorneys get the documents faster- which means their clients also get them faster, at a lower cost, and with fewer errors. (We've captured more of these examples in our Law Firm Productivity Kit.)

In the end, legal clients will shift more work to firms that offer the greatest value for every dollar billed. There's no going back to the days when hours were not monitored carefully or alternative billing arrangements were not an option. External pressures from increasingly sophisticated clients are shifting the legal landscape in ways that were never even dreamed of five years ago. 

As I spent the past week at the 2009 ILTA annual conference, I spoke with CIOs from leading law firms across the country and discussed ways to improve the levels of efficiency and client service at their firms. Everyone is on the same page now and it's an exciting time to be looking at how technology can help make a profound difference in legal productivity. 

In the July issue of The CPA Journal, professors Nancy T. Hill, John E. McEnroe, and Kevin T. Stevens of the College of Commerce at DePaul University, surveyed 2,700 CPAs engaged in audit, tax and advisory services to assess their views of Sarbanes-Oxley (SOX) now that it has been five years since adoption.  They found (based on 549 responses) that “differences in opinion seem to exist in all ranks and may indicate just how complex and far-reaching the implementation of SOX is … It could be the case that the day-to-day implementation issues at a particular client make it difficult to see the more intangible benefits that SOX may offer to the investing community.”

There was one partner from a big-four accounting firm who was quoted saying that SOX is a good thing and he forewarned that SOX was something that should not be ignored by those organizations that are not presently required to comply.

“The large majority of internal controls should be in place, regardless of public reporting requirements, to answer that the company is safeguarding its assets properly and that the larger organization is functioning in accordance with senior management’s and the board’s intent.  These controls must be independently reviewed or surely over time they will erode and become useless.  Hence, the bulk of the cost of a good system of internal control is part of the cost of doing business responsibly and should not be attributed to SOX!  Small companies have just as much responsibility to safeguard shareholder assets as do large ones.  The rewards to management for good results are huge.”

On the other side of the coin, a manager of a Big Four firm believes the costs outweigh the benefits:

“The only significant benefits to SOX have been to make auditors realize that their clients are the board of directors/shareholders and not management and [to eliminate] independence issues associated with many non-audit services that were obvious conflicts.  The remainder of SOX has resulted in minimal benefit (and possibly a net cost) to the public shareholders.  In my experience, SOX has resulted in a lot of meaningless flowcharts, checklists, procedures, etc.”

It’s clear that SOX is not going away.  In fact, we’ve seen no further easing of Section 404 requirements for small public companies and we’ve already seen it creeping into the lives of controllers and financial executives at non-public companies.  What if going public is on the horizon for the next year or two or five years out?  What will be the new requirements of your next round of financing?  When should SOX become an issue?  Wouldn’t it be better to consider your compliance issues now so it will not be an issue down the road?

As these two articles suggest -- Sarbanes-Oxley for Private Companies by Foley & Lardner and For Small Business, Procrastination is a Risky Option from the Boston Business Journal -- wouldn’t investors be more willing to become involved in a company that is already complying with the most important aspects of SOX than one that is ignoring it or hesitant to implement some of its best practices?