Two Step's Private Company Equity Management Blog

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. 

This is Part 1 of a three-part series offering excerpts from the Two Step Software white paper, "The Stock Option Valuation Game."You can read the entire 3-page article at http://www.twostep.com/news/whitepapers.asp.

Your 2007 audit may finally be completed, but don’t break out the bubbly just yet because your work is not over. The grace period for IRS Section 409A is coming to an end on December 31, 2008 and ongoing FAS123R and stock option backdating issues must be kept under control. Ignore these complex issues and like that first mole in the game of Whac-a-Mole, the errors will multiply and quickly become out of control. Most likely they will be uncovered at the start of your next financing, when you’re ready to sell the company, or as you prepare to take the company public … talk about bad timing.

If organizations want to stay in control, then they must focus the same amount of attention on stock option valuation as they do to other aspects of their financial reporting. The latest trap for privately-held companies is calculating the fair market value of the common stock that will serve as the exercise price for their employee stock options. The competing guidance under FAS 123R and Sec. 409A makes this a game your organization must win.

Let’s face it, imprecise valuation of the common stock underlying employee stock options is a pervasive problem that venture-backed and other privately-held companies must address. Prior to the new stock option expensing requirements under FAS 123R, the new deferred compensation plan rules under Sec. 409A, and the stock option backdating scandals of 2006, relatively little attention was paid to how a company determined the exercise price of employee stock options. But now, auditors, acquirers, the SEC, and the IRS are laser focused on valuation as it relates to equity compensation. And, they have no intention of losing.

Dan Kossmann, the Chief Financial Officer of Initiate Systems, Inc., knows something about the valuation game, having been the CFO for five organizations that went public, were acquired or received outside financing. He notes that stock option administration and reporting has become a more important part of the CFO’s job because of the focus on financial reporting and expensing by the press, regulatory agencies, board members and auditors. As a result, companies should improve their administrative infrastructures because of the potential exposure.

In fact, he considers the administration of stock option plans an essential financial reporting function, similar to processing payroll taxes. “You have to make sure the I’s are dotted and T’s are crossed because not doing so is now considered a dereliction of duty,” said Kossmann.

Coming next time… Part 2 -- The Impact of Incorrectly Determining Fair Market Value of Equity Compensation Expense.

In our education programs at Two Step Software, we provide basic training for those who do the difficult work of tracking and creating capitalization tables and offer other courses that focus on equity compensation accounting. However, for a change, we thought it would be useful to take one step back and help those who are responsible for basic cap table tracking (but aren’t "deal gurus") understand some of the deal terms that may not relate to cap table tracking at first blush.

While sometimes it’s the tracking that matters most, it’s also critical to understand the terms that relate to the investment side. If you’re responsible for tracking the equity in your company's capitalization table, you should be familiar with this terminology in order to understand how all the pieces fit together. This understanding will serve you well as new stock is being issued—or as more complicated equity instruments become involved, such as preferred stock, stock options, or warrants. 

Once the big numbers are determined -- such as valuation and how much the new investor will get of the company -- the details must be implemented: How many shares is the new investor going to get? How many shares of preferred will be issued for the agreed portion of the common stock? How do they convert? How does the increased option pool fit into the total capitalization? Will the liquidation preference increase over time? How do the investors participate in future rounds?  

I recently came across a set of blog posts from four years ago, written by an early-stage investor, Brad Feld, Managing Director of the Foundry Group and formerly of Mobius Venture Capital. His blog, worth reading, is full of outstanding writing and insightful commentary. Despite their age, these posts provide the equivalent of a half-day seminar on understanding venture capital terms for a stock plan administrator, junior finance department member, young corporate attorney, or corporate paralegal. If you've ever found yourself on a conference call where the discussion sounded like a foreign language, take a few minutes to read these articles. 

The four blog post titles are (click to view): 

“Venture Capital Deal Algebra” discusses the basic concepts of "pre-money" and "post-money" valuation and how to calculate the shares to be issued. Among the information it shares are some very simple formulas that could be extremely helpful for deal novices, such as:

The other three posts are self-explanatory based on their titles. They cover areas that many non-lawyers, non-CFOs and non-venture capitalists don't really understand (and in the sophisticated world of VC and private equity investing, few are bold enough to raise their hand and ask). Judging by the reader comments in these posts, it's also clear that even some investors and founders don't understand the terms completely.

It’s possible that these individuals have avoided the second tier of negotiation that is required to flesh out what a term means under specific circumstances (see: What Does Pro Rata Mean?). For every investor who has done a few deals in the past, it seems like these terms should be obvious based on the way they were used in those unique deals. But as these articles suggest, there are probably many other investors who have used them differently in their own deals.

If you are new to venture capital terms, read these blog posts and you’ll greatly increase the chances that you can actually understand what the terms mean on the Term Sheet and spend a little less time hoping no one asks.

Last month, more than 300 CFOs, controllers and other accounting professionals registered for our third in a series of webinars that Two Step Software presented this year on FAS 123R best practices. This one was called “FAS 123R Best Practices for Rock Solid Year-End Reporting: How to Prepare for Your Upcoming Equity Compensation Audit Before It's Too Late.” (You can download a recorded version of the presentation or the related white papers and checklists.)

The “hot topic” for this webinar was the new accounting standards104-111, effective for fiscal years ending Dec. 31, 2007, that one of our panelists, Daniel DeVasto, the CEO of Wolf & Company, P.C., referred to as some of the most far reaching changes in auditing standards in 25 years. I had originally heard Dan refer to these changes as the “cascading effects of SOX” since they require non-public companies to assess their financial statement risks and controls in similar fashion to the requirements under SOX Section 404.

This topic was particularly interesting to our audience since these new standards uniquely apply to the equity compensation accounts because they are considered “non-routine” significant accounts and non-routine accounts are areas that have “significant risks” associated with them. Since these types of accounts may have a greater risk of material misstatements, they require greater controls and may be subject to additional scrutiny by auditors. 

Dan’s presentation described non-routine transactions as those that involve:

• Management intervention to specify accounting policies;
• Manual intervention for data collection and processing;
• Complex accounting principles or calculations; or
• Estimates, especially those requiring assumptions about future events.

Clearly, stock option tracking, valuation under FAS 123R, and equity compensation amortization fit well within this category.

An auditor’s assessment of whether a company has appropriate levels of internal control over their financial statements will be based in most cases on the standard COSO framework:

1. Control environment
2. Risk assessment by entity
3. Information and communication systems
4. Control activities
5. Monitoring

Whether it’s because of SOX 404 or the new SAS 104-111 requirements, all companies with stock option plans or similar equity based awards will need to take a careful look at their equity compensation practices and evaluate the areas of risk and the types of controls that are appropriate. Starting this year, privately-held companies with audited financial statements can no longer escape the internal controls requirements that previously only affected publicly held companies subject to SOX.

You can link to the recording, slides and materials here.