Two Step's Private Company Equity Management Blog

Recent research conducted by faculty at the University of Illinois and Michigan State University finds that, on average, executives value their stock option holdings at 40% of the opportunity cost to the company. More important, however, is their finding that this “cost-value” gap can be closed by employing a short but effective personalized equity education program.

Net Worth Strategies, Inc. has repeatedly conducted studies at the National Association of Stock Plan Professionals Conferences and discovered that experts in equity compensation also underestimate the value of equity compensation holdings even though they understand valuation models and the leverage inherent in stock options. (Net Worth Strategies offers corporate education programs, a family of equity compensation planning software and advisor support services.)

Bill Dillhoefer, Vice President of Net Worth Strategies, addresses the cost-value gap in a white paper aimed at helping CFOs and CEOs maximize the effectiveness of their equity compensation programs. Dillhoefer believes that companies have a responsibility to take action to close this cost-value gap and should invest in a brief education program to bring the value more in line with the cost.

According to Dilhoefer, the payoff from personalized equity compensation education comes from the following three areas:

• Improved retention of key personnel. As all corporate officers know, the cost and pain of losing even one of your best and brightest can be staggering. If key people have embraced the full value of their holdings, outside recruitment discussions are likely to be short lived.
• Increasedmotivation of key personnel and alignment with corporate objectives. Executives who understand and have embraced the upside potential of their holdings, and the importance to their financial goals, are more likely to dedicate themselves to driving earnings and avoiding actions that might jeopardize the stock price.
• Responsibilityto owners for the full value from their investment in equity compensation. As a result of accounting scandals and new regulations, shareholders and groups that represent them have placed a spotlight on the dilution and income statement impact of equity compensation programs. To date, the focus has been on the cost side of the equation. As shareholders come to understand the cost-value gap, however, they are likely to focus on the value side as well -- particularly since the cost to close the gap is relatively small.

Because companies must book and expense options based on Black-Scholes or another approved valuation method, the existence of a “cost-value gap” raises important questions regarding the viability and effectiveness of stock option programs in fulfilling their stated purpose of motivating and retaining key employees.

In light of mandatory option expensing and increased shareholder scrutiny, a little more education will go a long way to ensuring that your employees realize the full value of their equity compensation. Read the white paper here.

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) recently announced the release of its discussion document: Guidance on Monitoring Internal Control Systems. The guidance which is extensive and goes into great depth applies to the internal control objectives over financial reporting, as well as the objectives related to effective operations and compliance.

According to COSO Chairman Larry Rittenberg, Ph.D., "This guidance more fully develops the monitoring component of COSO’s Internal Control - Integrated Framework,” and is appropriate for organizations of any size or structure to improve the quality of their internal controls systems for multiple business purposes, but especially those dealing with the reporting requirements under the U.S. Sarbanes-Oxley Act of 2002, Section 404.”

Of the two documents, the second, Internal Control – Integrated Framework Executive Summary, is an excellent summary of the five interrelated components of effective internal control (of which monitoring is the 5th component.) The five are: control environment; risk assessment; control activities; information and communication; and monitoring. COSO makes the point that while entities of different sizes may implement them in different ways, they are applicable to business of all sizes, large and small. The framework set out by COSO is worth reviewing at least annually by any organization and then choosing how to apply the framework, particularly for those where internal controls are not mandated by SOX.

COSO seeks feedback on the concepts in this discussion document until Oct. 31, 2007; they want to know if they are clearly articulated and if you agree with the conclusions reached. They also want to receive examples of innovative approaches you have taken in monitoring the effectiveness of internal control. They will consider these observations in the development of their final guidance. Accompanying the release of the discussion document is access to a Web-based feedback portal on the COSO Web site at www.coso.org/publications.htm.

The second phase of the monitoring project, scheduled for release after comments are received on this discussion document, will provide examples, case studies, and tools to assist all organizations in implementing effective and efficient monitoring. COSO’s intent is to release an exposure draft of the full implementation guidance later this year and to release the final guidance in the first quarter of 2008.

I encourage you to read both documents and consider how your equity compensation technology fits in with your overall internal controls and compliance objectives.

On September 10, 2007, the IRS issued Notice 2007-78,which permits taxpayers to bring nonqualified deferred compensation plans into documentary compliance with Section 409A of the Internal Revenue Code and the final regulations issued there under. Since the penalties for failing to satisfy Sec. 409A are extremely costly to both employers and employees, we encourage our readers to immediately seek legal counsel and to do their best in the next 90 days to insure their plans satisfy the requirements which are complicated and onerous. Under the final regulations issued April 10, 2007, the effective date for non-qualified deferred compensation plans and arrangements remains January 1, 2008.