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 3 of a three-part series.

If you're an employee receiving stock options or a manager awarding stock options, it seems you never can know enough. Equity compensation is a constantly changing field, and there's always something new on the horizon, whether it relates to understanding the vast array of equity instruments (options, restricted stock, ESPPs, RSUs, SARs) or navigating the complex accounting and tax issues.

When seeking answers, sometimes you need just a little more information in order to ask the right questions of your attorneys, accountants, and advisors. That's why so many Two Step users have turned to myStockOptions.com. It's an unbiased source of expert advice that you can start using for free. Then, you can upgrade to their Premium version for more in-depth information (which is well worth the small additional fee). myStockOptions.com recently celebrated its 10th anniversary and published a great article: Five Major Developments in Equity Compensation of the Past Decade.

The myStockOptions website says:

"Equity compensation can be complex and confusing. By educating you, or your advisor, we help you make smart financial decisions. With our independent and unbiased expertise, we encourage you to make the most of stock options, restricted stock, restricted stock units, stock appreciation rights, employee stock purchase plans, or performance shares.

"Our excellence is attested by our awards, our US patent, our contracts with major stock plan providers, and the praise of people who use the site. The award-winning educational content and tools of myStockOptions.com were developed by experts in financial planning, taxation, securities law, stock plan administration, and human resources."

If you need a reliable equity compensation resource, take a look at myStockOptions.com. I promise it will be time well spent. And when you're ready to simplify your ownership administration or equity compensation reporting, contact us at Two Step Software to see our system or find other great resources.

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 1 of a three-part series.

Want to know how much equity compensation to award a founder or senior executive? Look no further than "the startup executive compensation resource": www.compstudy.com. Now in its 10th year, the CompStudy survey is put out by J. Robert Scott, Ernst & Young, and academics from the Harvard Business School. It covers China, India, Israel, the UK and the U.S. According to the CompStudy website:

"CompStudy is the longest-running, most comprehensive survey of equity and cash compensation for top management positions and boards of directors at private companies in the technology and life sciences industries. The study results provide essential information for businesses and investors who want to stay abreast of current trends in senior executive compensation and organizational structures."

CompStudy offers an irresistible deal: if you complete the 2010 survey and send along your information (which will be kept anonymous), you'll get a free copy of the survey - much better than paying $999! If you need this type of information as you're planning your equity compensation awards, take the survey and get your free copy of the 2010 results when they come out. Or if you can't wait, you can purchase the 2009 survey today.

I was impressed with last year's survey and consider CompStudy to be a great resource for our law firm users, who have clients that need knowledgeable advice on what to award key employees. It's also helpful for our CFO customers, who need to ensure that their total compensation packages compare favorably to the market.

If you have questions or remarks regarding CompStudy, feel free to add them to the Comments section. And when you're ready to simplify your ownership administration or equity compensation reporting, contact us at Two Step Software to check out our system.

With the transitional period for Section 409A ending on December 31, 2008,now is the time for organizations to review their equity compensation reporting practices and correct any oversights. Such action will help to avoid the onerous penalties of Sec. 409A and prevent them from thwarting your next critical financial transaction. Miss this last chance and you may find that you’re the one getting whacked.

Companies have started to pay more attention to valuation ever since FAS 123R option expensing became mandatory. To provide more supportable results, companies need to document and create procedures for granting stock options that satisfy both valuation and backdating concerns. Then, use an independent third party to provide a written report on the fair market value of the company’s common stock that satisfies the requirements of both the FASB and the IRS.

Despite the costs, the lower perception of bias and a more trusted outside methodology will provide a better result and potentially less scrutiny. Scott Goodwin, a partner at Wolf & Company in Boston, noticed, “After layering on the 409A requirements, investors pushed almost all of their VC-backed companies to get formal valuations to get a more accurate stock valuation for tax purposes and to feed into their FAS 123R reports.”

In the end, there’s no substitute for actually documenting a company's internal controls over stock option granting and reporting procedures. Auditors are now required to evaluate a non-public company's internal controls over financial reporting. Under Statement on Auditing Standards No. 112, they must report to management and "those charged with governance” any material weaknesses in internal controls which would include those related to equity compensation accounts.

Since equity compensation accounts are considered “non-standard "accounts, they will receive greater scrutiny. “Companies should take responsibility for documenting and establishing an appropriate internal control system and not view this as an exercise in just satisfying their auditors because management is ultimately responsible for it, "advises Goodwin.

If companies do not pay attention to valuation and stock option backdating, auditors, acquirers, and regulators will discover these issues. That discovery is certain to magnify problems that could have been fixed. The result will be financial and tax issues for both the company and its employees. When a company motivates with incentive equity compensation, the last thing it wants to do is frustrate its team with unnecessary financial or tax headaches that could have been prevented.

Dan Kossmann, the Chief Financial Officer of Initiate Systems, Inc., recalls that stock option compliance was not historically considered a finance function, but was rather a legal or human resources matter. Regulatory complexities have, however, changed the rules of the game and placed accountability with the CFO.

When a company inadvertently grants stock options to its employees below fair market value or is deficient in its reporting, it may be "game over” for the management team. Play by the reporting rules and you and your organization can dramatically increase your chances of winning the stock option valuation game.  

This was Part 3 of a 3-page white paper. Read the full article now at http://www.twostep.com/news/whitepapers.asp - “The Stock Option Valuation Game"

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.

In connection with the Two Step webinar: FAS 123R Best Practices for Rock-Solid Year End Reporting – How to prepare for your upcoming equity compensation audit before it’s too late, Two Step has partnered with the National Center for Employee Ownership (NCEO) to offer special discounts off the purchase of its best-selling equity compensation books, including The Stock Administration Book (written by Amy Yamashiro, one of our webinar panelists).

The Stock Administration Book is a detailed guide that addresses the real-world scenarios faced by stock administrators. It's a must-read at Two Step Software and we recommend it to our customers.

"The Stock Administration Book is an essential desk reference for any new stock plan professional. The templates provided make it simple to drop in company specific information and quickly build comprehensive processes and procedures, removing the headache from this process!"

Emily Cervino, Director,
Program Development and Curriculum,
Certified Equity Professional Institute,
Santa Clara University

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To take advantage of this special offer, go to www.nceo.org/twostep and use these promotional codes (good only through Dec. 24, 2007):

The Stock Administration Book at $35 each
Code: FRADMIN

The Stock Options Book at $10 each
Code: FRSTOCK

Selected Issues in Equity Compensation at $10 each
Code: FRSELECTED

$20 off NCEO membership
Code: MEMBER20