Two Step's Private Company Equity Management Blog

I met Terry Adamson of Radford Surveys + Consulting, a part of Aon Consulting, at the October 2007 NASPP meeting in San Francisco. He is one of the nation's leading stock option and FAS 123R valuation experts and I wanted to pass along this article that he authored that addresses a few key questions related to forfeiture rates and so-called "true-ups." Its title is: A Technical Roadmap to Expense Allocation Under FAS 123(R).

While the details of the specific approach and examples that Terry provides in this paper are extremely technical and perhaps challenging for many companies that may have smaller or newer plans, the general guidance on expense allocation is extremely useful and can be quickly understood by reading initially his short Overview and Summary.

His overview points out that in his opinion:

" ... it will become best practice to reconcile forfeiture experience quarterly based upon individual option grants, and therefore any incremental changes in estimates will consistently be re-amortized over the requisite service period during interim periods. This approach will lend to less volatile financial statements comparatively against less frequent reconciliations."

It also reiterates some background which is useful to everyone:

"FAS 123(R) allows companies to recognize compensation cost for an award with a graded vesting schedule either on a straight-line basis for each separately vesting portion ("tranche") of the award (consistent with Financial Interpretation Number 28) or on a straight-line basis for the entire award. However, the amount of compensation cost recognized at any date must at least equal the vested portion at that date."

In summary, he states:

By reconciling less frequently than every interim reporting period (whether quarterly or annually), some troubling results may occur:

• Shares that have already been forfeited will continue to recognize compensation expense until the point of time that reconciliation occurs. This is most troubling when reconciliation occurs at the Vesting Date, as that may not occur for several years.
• Expense recognition patterns will be more jagged with less frequent reconciliation and will have greater probability of material error. Therefore, companies who reconcile their awards more frequently will have expense patterns that are more predictable.

Whether a particular company chooses to reconcile quarterly or annually should be based on the unique reporting requirements of the company and particularly whether it is public or private. In either case, the article clearly stresses the importance of reconciling on a more frequent basis than solely on vesting dates, a sentiment that is shared by other leading FAS 123R valuation experts.

Link to paper: http://www.radford.com/home/ccg/valuation_services/Whitepaper_Aon_expense_allocation.pdf

If your company offers incentive stock options and/or an employee stock purchase plan, you need to file the annual information statement for each employee who exercised an incentive stock option in 2007 or transferred stock acquired under an ESPP by January 31, 2008. This is not a new requirement for 2007, but many law firms put out reminders in December or January each year since the penalty for failing to provide the information statement to employees can be expensive - $50 for each filing up to $100,000.

New for 2007 was a filing requirement that required companies subject to the Section 6039 reporting requirement for employees to also file a similar return with the IRS. However, in a last minute reprieve, the IRS has temporarily waived the obligation to file the new information return with the IRS for stock transfers covered under Section 6039 for 2007. The annual obligation to provide an information statement to employees remains in effect.

Pillsbury Winthrop Shaw Pittman sent out an Alert dated January 3, 2008 to its clients which summarizes the requirement to provide stock transfer information to employees as follows and also lists the specific information to be provided:

Section 6039 of the Internal Revenue Code requires that corporations provide a written statement to each current and former employee who receives stock pursuant to the exercise of an incentive stock option or who transfers for the first time stock received under an employee stock purchase plan (ESPP). The statement must be provided by January 31 of the year following the calendar year in which the stock transfer was made.

The IRS provided the following in IRS Notice 2008-8 waiving the new filing requirement with the IRS for 2007:

The Treasury Department and the IRS intend to issue regulations that prescribe rules relating to the information return requirements contained in § 6039, as amended by the Act. The Treasury Department and the IRS expect that the forthcoming regulations generally will retain the existing rules contained in § 1.6039-1, relating to the information statements to be provided to employees, and generally require that the same information be included in the information returns made with the IRS. The Treasury Department and the IRS also expect that the new §6039 regulations will be effective retroactively to January 1, 2007.

Because regulations under § 6039 have not yet been issued, the IRS is waiving the obligation to make an information return for 2007 stock transfers governed by § 6039. However, corporations should continue to furnish to employees the information required by, and in accordance with, existing § 1.6039-1, with respect to such stock transfers.

Stay tuned for more information related to the new IRS filing requirement later this year. In case you were not aware of it already, add the new filing to your ticklers for January 2008 and stay tuned for updated information from the IRS.

Are you concerned about estimating your stock option expense because you are a company that has little or no historical exercise data and you thought you’d be losing the simplified method under SAB 107?

If so, you’ve been granted a reprieve by the SEC.

The safe harbor of SAB 107 (released in March 2005) for estimating the expected term for employee stock options has been extended beyond Dec. 31, 2007 by SAB 110, released by the SEC on Dec. 21, 2007.

While most companies are saying thank you, the rest are saying “it’s about time.”  One of the single most asked questions related to using the Black-Scholes formula had been “what were companies with no data to estimate the expected term supposed to do when SAB 107 expired?”  With 10 days to go, the SEC finally responded.

A nice summary is available in the SEC press release at: http://www.sec.gov/news/press/2007/2007-267.htm

As a result of SAB 110, eligible companies, both public and privately-held, are able to continue to use the simplified method under SAB 107 for estimating expected term if their own historical experience isn't sufficient to provide a reasonable basis for such an estimate.

As stated in Release 2007-267:

Specifically, SAB 107 provided a simple rule for estimating the expected term of what it called a "plain vanilla" option: it would be just the average of the time to vesting and the full term of the option. Companies could use this simplified method until Dec. 31, 2007.The new assistance that is being issued today, SAB 110, extends the opportunity to use the simplified method beyond Dec. 31, 2007.

The Interpretive Response section of SAB 110 states:

… the staff understands that an entity that is unable to rely on its historical exercise data may find that certain alternative information, such as exercise data relating to employees of other companies, is not easily obtainable. As such, some companies may encounter difficulties in making a refined estimate of expected term. Accordingly, if a company concludes that its historical share option exercise experience does not provide a reasonable basis upon which to estimate expected term, the staff will accept the following "simplified" method for "plain vanilla" options consistent with those in the fact set above: expected term = ((vesting term + original contractual term) / 2) …” Note: the Staff uses a weighted-average formula for “vesting term.”

At the same time, the SEC has modified its previous position and now only permits the use of the SAB 107 method if the “company does not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term.” In the past, a company could have used the simplified method even if it had a greater amount of historical exercise data.

The SEC explained that at the time that SAB 107 was released, it had expected that historical information about employee exercise behavior from other companies, such as actuarial studies, would soon be readily available. This was the basis for the statement in SAB No. 107 that the Staff would not expect a company to use the simplified method after Dec. 31, 2007. Since such information is not yet available, the Staff removed the deadline.  It is likely that once such data is available, the SEC may again prohibit the use of the SAB 107 simplified method.