Two Step's Private Company Equity Management Blog

Near the end of 2009, I posted the article, Be Happy Generating Your FAS 123R Year-End Disclosures. Now that the 2009 audit season is coming to a close, I wonder how many private companies truly had a stress-free audit? How many were able to quickly generate their FAS 123R (ASC Topic 718) disclosures and are now lounging on a beach in Jamaica, listening to Bob Marley tunes? And how many are still gathering all of the cumbersome back-up details requested by their auditors?

Our customers who are using Equity Focus are already generating their FAS 123R disclosures with ease.

For one Two Step customer, generating the FAS 123R disclosures is old hat. This company maintains their option transactions in Equity Focus as they happen. As a result, they only need to review the transactions at audit time. At that point, the customer provides their auditors with two reports and a few Excel spreadsheets with back-up data - all generated by Equity Focus. The process couldn't be simpler, and because they just completed their third audit with this information, this customer's stress level is much lower than in the past.

Some customers whose audit is coming up later this year are already using Equity Focus to get a jump on generating their disclosures. Last night, I spoke with a CFO whose company has their audit in May. Last year was their first year using Equity Focus - and they started using it just before the audit. Of course, it was a mad scramble to get all of the information into Equity Focus, but the system was able to generate the necessary disclosures just in time. This year, because Equity Focus is already in place, it's just a matter of reviewing the option transactions from the previous year, running a few reports, and working with their auditors. With two months remaining until their audit, that CFO's office is as calm as can be.

I'd love to hear about your experiences generating your FAS 123R year-end disclosures. Share it by answering the poll question below:

If you voted "No," check out an Equity Focus demonstration to see how you can generate your FAS 123R disclosures quickly - and without the usual headaches.

Do you have a success story (or horror story) relating to generating the FAS 123R disclosures for your year-end audit? If so, feel free to share it in the comments section below or email me at: jwright@twostep.com.

As noted in my recent blog posts, helping busy CFO's learn how to generate the disclosure requirements of FAS 123R (now ASC Topic 718) and the two prior steps described below (valuation and amortization) reminds me a little of watching my one-year old son learn to take one step at a time. Because the primary goal of equity compensation reporting is creating the requisite financial statement disclosures, let's continue with the third and final step a typical, privately-held, venture-backed company needs to understand to properly report equity compensation expense related to "plain vanilla" stock option grants. In case you are more advanced, please note that this article addresses the basics of FAS 123R.

For background reference, note the previous blog articles Part 1 and Part 2 of this 3-part series:

1. Part 1: Valuation and Black-Scholes Variables
2. Part 2: Expensing Stock Options
3. Part 3: FAS 123R Reporting Disclosures

Learning to Walk - Reporting the Expense and Related Disclosures

Now that we've learned to generate the fair value of an option grant using the Black-Scholes formula and how to amortize the fair value of an option grant over the requisite service period, we are now able to generate the requisite financial statement disclosures.

When working with plain-vanilla option grants, at a minimum, you will need to report these disclosures relating to your option valuation and expensing. These disclosures are now described in detail in ASC Topic 718-10-50. Under FAS 123R, you would find this information in Paragraph A240.

When looking at these disclosures, I like to break it down into three sections.

Section 1 - Valuation Summary

For the options granted in the current reporting period, you need to disclose the "range" and "weighted average" values for certain variables used in the Black-Scholes formula: volatility, interest rate, expected term, and dividend rate.

1. Range - To determine the range for each variable, you need to disclose the lowest value and highest value used for each. For instance, if a 20% volatility was the lowest value you used when determining fair value for the options granted in the reporting period and a 30% volatility was the highest value for the same period, the range you would disclose would be 20%-30%.
2. Weighted Average - To determine the weighted average for each variable, you need to "weight" each variable based on the number of shares granted at each value. The total number of shares granted is then divided by the sum of the weights to end up at the weighted average. For instance, if there is one grant for 1,000 shares with a 25% volatility and another grant for 500 shares with a 30% volatility, the weighted average volatility would be: (25*1,000) + (30*500)/1,500 = 26.67%.

When you disclose the range and weighted average values for each of the four Black-Scholes variables (volatility, interest rate, expected term, and dividend rate), as well as the range and weighted average values for fair value per share, you will be disclosing a total of 10 values in the valuation summary section.

Section 2 - Option Activity

For option activity in the current reporting period, you need to disclose the number of options outstanding at the beginning of the period, the option activity during the period, and several numbers related to the end of the period. The requisite disclosures breakdown as follows:

1. Total Outstanding at the start of the period - This is the total number of options outstanding as of the beginning of the period. If the reporting period is 1/1/2009 - 12/31/2009, this is the total number of options outstanding at the end of the day on 12/31/2008. The number outstanding at the start of the period will be: Total Granted - Exercises - Forfeitures - Expirations.
2. Grants during the period - This is the total number of options granted during the period, even if those grants were cancelled during the period.
3. Exercises during the period - This is the total number of options exercised during the period.
4. Forfeitures during the period - This is the total number of options cancelled during the period prior to vesting.
5. Expirations during the period - This is the total number of options cancelled during the period that were vested.
6. Total Outstanding at end of the period - This is the total number of options outstanding at the end of the period. The Total Outstanding at the end of the period is: Total Outstanding (at start) + Grants - Exercises - Forfeitures - Expirations.
7. Total Exercisable at end of the period - This is the total number of options that are exercisable at the end of the period. The Total Exercisable at the end of the period is: the number of options that have vested - the number of options that have been exercised for outstanding option grants.
8. Total Unvested at end of the period - This is the total number of options that have not yet vested at the end of the period. The Total Unvested at end of the period is: the number of outstanding options less the number of those options that have vested.
9. Total Vested or Expected to Vest at end of the period - The Total Vested or Expected to Vest at end of the period is: the sum of the number vested + the number expected to vest.

1. Grants during the period - The number vested = the number that are exercisable at the end of the period (Item 7 above). You don't use the number "vested" here, because it is possible that a portion of the vested shares have been exercised. You want to look only at the number of vested shares that can be exercised at the end of the period.
2. Exercises during the period - The number "expected to vest" is the number that is "projected to vest" at the end of the period. This value is the number of shares that are outstanding but have not yet vested at the end of the period (Item 8 above) after applying the annualized forfeiture rate, as described in the Part 2 article that discusses how to expense option grants.

For each of these nine disclosures, you also need to disclose the weighted average exercise price. For example, if there was an option granted for 1,000 shares at an exercise price of $2 and another option granted for 1,000 shares at an exercise price of $3 during the year, the weighted average exercise price for the number granted during the period (Item 2 above) would be: (1,000*2) + (1,000*3)/2000 = $2.5. Therefore, for each of these disclosures, you need to look at each individual grant, exercise, or cancellation that goes into the calculation and calculate the weighted average exercise price. A standard formula for weighted average exercise price for each item above could be expressed: (SUM(Disclosure Item for that grant * Exercise Price for that grant) for all option grants used in the Disclosure Item)/SUM of that Disclosure Item.

For disclosures 6-9, you also need to disclose the weighted average remaining contract term. For this calculation, you must first determine the remaining contract term for each option and then apply a weighted average based on the number of shares. The remaining contract term is calculated for each option by taking the number of days left between the reporting period end date and the date of expiration for that grant and dividing by 365 (because the value is disclosed as a number of years). A standard formula for weighted average remaining contract term for each item above could be expressed: (SUM(Disclosure Item for that grant * Remaining Contract Term for that grant) for all option grants used in the Disclosure Item)/SUM of that Disclosure Item.

For disclosures 6-9, you may also need to disclose the aggregate intrinsic value. Intrinsic value is the difference between the fair market value at the end of the reporting period and the exercise price of the option. Aggregate intrinsic value is the total of the intrinsic value for all the options included in the calculation for the disclosure item for the current reporting period. This value is not always required for privately-held companies because for many the fair market value changes infrequently. However, if you have the data, you may choose to include it. A standard formula for aggregate intrinsic value for each item above could be expressed: SUM(Disclosure Item * (Fair Market Value on Reporting Period End Date - Exercise Price for that Grant)) for all option grants used in the Disclosure Item. For instance, assume the fair market value of an option on the reporting period end date is $3. Then, assume there is an option grant for 1,000 shares outstanding at an exercise price of $2 and another option grant for 500 options outstanding at an exercise price of $1. The aggregate intrinsic value would be calculated: (1,000 * ($3 - $2)) + (500 * ($3 - $1)) = $2,000.

Section 3 - Expense Recognition

When reporting your expense, at a minimum, you should report the following information:

1. Projected Fair Value - This is the total amount of expense expected to be recognized. This includes everything expensed to date, the amount being expensed in the current period, and the amount to be expensed in future periods.
2. Expense Reported - This is the amount of expense recognized prior to the beginning of the current reporting period.
3. Projected Expense - This is the amount of expense that you expect to recognize in the current period based on the amortization schedule at the beginning of the period or at grant date (if the option was granted during the current period).
4. True-Up Amount - If you are recognizing a "true-up" during the current period, then this is the total credit or debit being reported in the current reporting period.
5. Expense to Report - This is the total amount of expense being recognized as equity compensation expense in the current reporting period. This would be: Projected Expense + True-Up Amount.
6. Total Reported Expense - This is the total amount of expense that has now been recognized through the end of the current reporting period. This would be: Expense Reported + Expense to Report.
7. Remaining Expense (otherwise known as Unrecognized Compensation) - This is the amount left to expense over the remaining service period after the current reporting period. This would be: Projected Fair Value - Total Reported Expense.
8. Weighted Average Period to Recognize Unrecognized Compensation - This disclosure is an estimate of the amount of time it will take to fully expense the remaining amount of unrecognized equity compensation expense. To calculate the remaining period left to expense all option grants, you take the number of months from the current reporting period end date for each option grant * the unrecognized expense for that future period. The sum of this value for all grants is then divided by the total unrecognized expense. This will be the weighted average period left to recognize the unrecognized equity compensation expense. Note that this disclosure should be reported based on a number or years, such as 2.25 years. If you would like to see a sample of how I determine this number in Excel, please email me at jwright@twostep.com.

These are the minimum required disclosures for plain-vanilla stock option grants related to equity compensation reporting for non-public companies. Your audit firm may require additional disclosures. In addition, I did not cover disclosures required for restricted stock or disclosures that are not related to stock options. If there are other items that you have questions about, please let us know.

I hope that this series on valuation, expensing and disclosures under FAS 123R (now ASC Topic 718) has helped you understand the basic steps related to this very complicated task. There are many interconnected pieces to determining the calculations, variables, expensing and reporting. That is why it is often difficult to do all these steps using multiple related spreadsheets.

If you are interested in seeing how a consolidated online equity management system can make it much easier to generate these disclosures, watch the four minute video Introduction to Equity Focus. Let us know if you think our system might make this work easier, more accurate, and save time.

As I was starting to write the first part of my new blog series: Five Ways to Perform Year-End Equity Management and FAS 123R Reporting Faster, I received an email from a new customer who recounted a conversation he imagined between him and his auditor. It was timely because it set out nicely how an equity management system would make year-end FAS 123R reporting faster and save audit fees.

Mr. Auditor*: How did you come up with a discount rate of X% and volatility of Y%?

Controller*: It was actually done by our FAS 123R reporting system, Equity Focus, using Yahoo closing price data for the selected peer companies and interest rates from the Federal Reserve site.

Mr. Auditor: How do I know I can trust your numbers? Got any back up showing how you came up with the discount rate and volatility?

Controller: Here's a report that sets out all of the discount rates used by period and stock closing prices for the selected companies by day for the expected term period, as well as the formulas used to derive the volatility. Have fun. Now leave me alone.

*Names have been changed to protect the guilty.

That hypothetical conversation when the same equity management system is used to do all of the stock plan administration and FAS 123R disclosures is short and sweet. It illustrates why using a consolidated system decreases the time a FAS 123R audit takes. The auditor asks the questions that need to be asked when doing a FAS 123R audit in order to get the back-up data for the assumptions. The Controller or CFO can quickly provide the auditor with all of the back-up information with just a click of a button. That can only be done if you're using an automated equity management system.

Now, let's compare that "happy" conversation to a "sad" one I imagine a lot of private companies have with their auditors if they're still using Excel spreadsheets.

Mr. Auditor*: How did you come up with a discount rate of X% and volatility of Y%?

Controller*: I had to go to Yahoo Finance to download the closing prices for each of my peer companies. Then, I went to the Federal Reserve site to download the interest rates. I then did these crazy calculations and used them to generate my fair value. Here are my spreadsheets showing the fair value calculations and expense for the period.

Mr. Auditor: How do I know I can trust your numbers? Got any back up showing how you came up with the discount rate and volatility?

Controller: (Sound of papers rustling and mouse buttons clicking in the background) I can't find the back up information. I may have misplaced it after using the variables in my calculations. Trust me. I followed all the steps we discussed last year to generate those values.

Mr. Auditor: That's not going to cut it. I need to see exactly how you came up with those variables. You'll need to do them again before I can accept your disclosures.

Does that sound vaguely familiar? If so, that's exactly why an equity management system should be used to generate your FAS 123R disclosures and turn that frown into a smile.

If you have a similar story, I encourage you to share your experience in the comments.

Download our FAS 123R Productivity Kit for more information on how you can get your FAS 123R reporting done faster, better, and save audit fees.

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.

As the 2008 proxy statement season approaches, John W. White, Director, Division of Corporation Finance of the U.S. Securities and Exchange, looked back and commented on executive compensation disclosures in the 2007 proxy season at last month’s Annual Proxy Disclosure Conference in San Francisco on October 9th. His speech is very helpful in guiding companies to two areas they should focus on in 2008 and where the Staff will be looking to comment in the 2nd year under the new requirements. The new disclosure requirements were effective for proxy statements filed on or after Dec. 15, 2006.

In his summary thoughts from the speech “Tackling Your 2008 Compensation Disclosures,” he commented on a Staff report by the Division of Corporate Finance (released in early October based on their review of the Compensation, Disclosure and Analysis section of 350 filings), as follows:

The Commission made clear in adopting the new rules, however, that it is looking for more than just the value of the components of compensation and a total value of compensation. What is that “more” it is looking for? In order to provide investors with more than just tables of numbers, the Commission created the new Compensation Discussion and Analysis requirement to “put into perspective for investors the numbers and narrative that follow it.” This “overview” is very much a principles-based requirement, like the MD&A section with which we are all so familiar.

… When looking at first-year disclosures, we often found it difficult to understand how companies used targets or considered qualitative individual performance to set compensation and make decisions. …

… Far too often, meaningful analysis is missing — this is the biggest shortcoming of the first-year disclosures. Stated simply — Where’s the analysis?

He then went on to present his recommendations for 2008 proxy disclosures:

… Don’t let this coming year’s disclosures be just a mark-up of the first year. Instead step back and ask some very important questions.

• What is material to my shareholders, to my investors, as they examine the compensation of our executives and make their voting decisions for our board of directors and investment decisions with respect to our company?
• What are the material elements of individual executive and corporate performance that are considered in setting executive compensation?
• What is the relationship between the objectives of our compensation program and the different elements of compensation?
• What are the material factors that relate to our compensation decision-making process?

Then, sit down and focus on two very important aspects of your disclosure:

Analysis. Focus on how and why you reached the compensation decisions you made in your CD&A. Don’t provide a laundry list of facts. Discuss and analyze the elements of your decision-making. Some have suggested that the way to ensure proper emphasis of analysis is to require companies to provide a separate section titled “Analysis” in the CD&A. This suggestion is one of many good ideas. I will leave it to you, however, to determine how best to highlight the analysis.

Presentation matters. Focus on being clear, concise and understandable. Our rules require you to provide substantial amounts of information. Consider ways to present your information in a manner that helps people understand it. Consider presenting layered disclosure. Consider using tables and charts to present complex information. Continue your innovative efforts to use these tools to illustrate the relationship between compensation objectives and different forms of pay.

Read the entire speech at: http://www.sec.gov/news/speech/2007/spch100907jww.htm

On June 5th, John W. White, Director, Division of Corporation Finance, U.S. Securities & Exchange Commission, testified before the U.S. Senate Permanent Subcommittee on Investigations.  He covered a wide range of issues concerning stock options, executive compensation disclosure, option backdating, and FAS 123R.

In his testimony, White candidly admitted two areas of failure.  First, he stated that while Section 162(m) (added to the IRS Code by the Omnibus Reconciliation Tax Act in 1993) had been intended to curtail excessive compensation (in excess of $1 million) to top executives, instead it simply moved compensation from cash to stock options which were exempt from Section 162(m).  He quoted SEC Chairman Christopher Cox from his testimony to the Senate in 2006 when Cox admitted: “the stated purpose[of Section 162(m)] was to control the rate of growth in CEO pay. With complete hindsight, we can now all agree that this purpose was not achieved.”

And second, he acknowledged that the changes to the executive disclosure requirements for proxy statements added at the end of 2006were the first “significant revisions of its rules for executive and director compensation disclosure in more than thirteen years.”  He summed up by stating: “Simply put, the disclosure required of companies in their public reports failed to keep pace with changes in the marketplace.”

After these admissions, he went on in a good natured way to discuss some of the ways in which the disparity between the accounting treatment for tax and financial reporting of options, while potentially reduced, continues to exist even after the changes introduced by FAS123R which requires expensing of stock options.  A few segments from this part of his testimony follow:

… comparing the financial reporting and tax systems is a bit like comparing apples to oranges, it is more complicated than that. For the years prior to 2006, before FAS 123R was effective for most companies, the comparison was more like apples to automobiles. How a company calculated stock option compensation costs was based on a set of rules that differ significantly from those in place today. Before FAS 123R, most companies expensed options in accordance with Opinion 25, which in most cases meant that no expense was recognized because the option was granted at-the-money … Comparing how a company calculates stock option compensation costs and tax deductions for those costs after FAS 123Rtakes us back to the apples to oranges analogy.

“The compensation expense a company recognizes in its financial statements is tied to the fair market value of the option at the time of grant, whereas the tax deduction is tied to an option's intrinsic value at the exercise date....

“The adoption of FAS 123R by most companies in 2006 will no doubt reduce the book-to-tax differential, but the magnitude and timing of this impact is difficult to predict. That is because, under FAS 123R, companies will recognize the expense associated with an option grant in the financial statements (amortized over the vesting period) prior to any tax deduction being reflected on exercise of that option. If the tax system for companies was changed to bring it into conformity with the financial reporting system, one effect would be to accelerate the timing of a company's tax deductions.”

His full June 5th testimony can be read at: www.sec.gov/news/testimony/2007/ts060507jww.htm

I highly recommend reading his testimony.  It’s like a primer covering historical aspects of stock options, current stock option backdating issues, new executive compensation disclosures, FAS 123R, and tax and financial reporting.  Whether you’re a novice or an expert, looking to learn more about options or just learn the SEC’s latest thinking, you can get through it in one cup of coffee.