Two Step's Private Company Equity Management Blog

At Two Step Software, we sometimes feel like the Good Samaritans hot line when a CFO, Controller, or stock plan administrator tells us confidentially that they think they may have a “spreadsheet problem.” They don’t know who to turn to. They call us, often late at night, since we’re just a warm body at the other end of the line. Someone to talk to. Some don’t even call. They use email. A few … anonymously.

Well, we know what they’re going through and it’s so much more common than they realize. We see it every day, but they think they’re the only one who’s ended up this way. They imagine they’re the last CFO in Silicon Valley who’s afraid to move away from the comfort of their old, trusted Excel spreadsheets. There’s no question that converting to a fully-automated stock plan administration system is a big step. But like so many other important decisions in life, there are classic tell tale signs that it may be the right time.

At Two Step, we use a list of 10 warning signs to determine whether it's time for someone to stop using spreadsheets for stock plan administration:

1. You’re starting to feel pressure from those who care about you (maybe the CFO, General Counsel, or your auditors) to get control of your spreadsheets.
2. You’re no longer proud of your capitalization tables and corporate governance practices.
3. Handling stock option exercises and vesting schedules is starting to get in the way of other work and even family matters.
4. You haven’t been honest with your colleagues about how much time you’ve been spending updating the fully-diluted capitalization tables.
5. You’ve been postponing getting up to speed on FAS 123R and once you even “blacked out” doing a Black-Scholes valuation with a high expected volatility.
6. You’ve exceeded the 100 stock and option record limit.
7. You have a dangerous combination of common stock, convertible preferred stock, and stock options.
8. You’re using more than 3 spreadsheets at the same and you can no longer figure out how to calculate the number vested and exercisable at any point in time.
9. You’re required to report your capitalization information to third party stakeholders, such as outside investors, lenders, an insurance company and the Board of Directors.
10. You plan to seek outside financing in the next 12-24 months or your exit strategy includes being acquired by a publicly-held company.

If you answered yes to at least three of those cases, “you have a problem.” It’s not too late to seek help, but it is time to consider moving to a fully-integrated, consolidated, browser-based, stock plan administration system. You’ll not only improve your stock and option tracking, but you’ll be able to automate complex calculations, generate great looking reports that you can be proud of, create fully-diluted capitalization tables in real time, and ease the accounting burden of FAS 123R reporting.

Like so many other major decisions in life, if you postpone for another week, another month, or another year, it will only make the eventual transition even more difficult. As the camera pans around the cheap motel room full of family, friends and co-workers, you hear their voices calling out: “Do it today. You’re a wreck. We’re only looking out for your best interests.”

Sometimes a good metaphor can be taken too literally. When we started saying that our stock plan administration system Equity Focus handled FAS 123R valuation and amortization in “one click,” we received a flurry of excited emails. CFOs from venture-backed companies wanted to know how we calculate all of the inputs for valuation and expensing with just “one click.” And of the six inputs for Black-Scholes, they were most interested in how we calculated expected volatility for nonpublic companies. As they say, "if it sounds too good to be true, it probably is.” While we don’t want to admit to being overzealous in our tag lines, what we meant was that Equity Focus reduces the complexity of tracking stock options and, “once you have your inputs for valuation,” it will calculate the fair value of each option grant and the amortization schedule for any period "with one click."

It's All About Volatility: There are six inputs for the Black-Scholes formula: exercise price, fair market value on the date of grant, expected volatility, expected term, expected dividends, and risk-free interest rate. For a privately-held company, the most difficult one to determine and the one with the greatest impact on valuation is expected volatility. The latest PCAOB Questions & Answers for auditors entitled Auditing air Value of Share Options dated Oct. 17, 2006 emphasizes this by stating in A7: “The expected term and expected volatility assumptions have the highest risk because they involve the greatest amounts of judgment and have a significant effect on the estimated fair value.” Unfortunately, when it comes to estimating expected volatility for nonpublic entities, it’s really more of an art than a science. Hence, the great desire for a “one click” solution.

What FASB Says: FAS 123R paragraph A22 states: “A nonpublic entity will need to exercise judgment in selecting a method to estimate expected volatility and might do so by basing its expected volatility on the average volatilities of otherwise similar public entities. For purposes of identifying otherwise similar entities, an entity would likely consider characteristics such as industry, stage of life cycle, size, and financial leverage.” And certainly the suggestion by FASB that the company “will need to exercise judgment” may be the understatement of the year. If there are no similar peer companies, then FAS 123R paragraph A45requires a company to estimate its expected volatility “by substituting the historical volatility of an appropriate industry sector index,” as described in paragraph A46.

FASB should have said: “Don’t try this at home” or “Volatility should only be handled on a closed course by a professional driver.” The lesson is don't take your inputs out for a test drive a few weeks before your auditors are going to arrive.

Get Help: At Two Step, we recommend that privately-held companies that do not have historical data with which to calculate expected volatility or have not developed internal expertise with FAS 123R seek outside assistance in determining appropriate values for volatility and other inputs for the Black-Scholes valuation model. Just running the Black-Scholes formula mechanically without a reasonable understanding of the subtleties of the inputs is unlikely to result in a satisfactory valuation that will withstand the scrutiny of your auditors this year and eventually the even tougher review of the Big 4 auditors for your next venture round or the public company that may acquire your company down the road.

Resources: There are many excellent resources out there that can assist a company with determining reasonable inputs for stock option valuation. The spectrum of consulting firms provide different levels of service designed for different types of companies and at varying prices. Two well known firms that are highly-focused on FAS 123R consulting and have worked with many publicly-held companies are: Equity Methods and FAS123 Solutions, LLC.  Two other companies that provide excellent FAS 123R consulting services to both smaller public and nonpublic companies are iComp, LLC and CFO Professional Services.

If you are accounting for your stock options under FAS 123R, start by taking the time to insure that your inputs are well justified and that the supporting documentation will satisfy your auditor’s scrutiny. They are required to evaluate the assumptions that go into your stock option valuations. And, since you’ll be applying the same method consistently year after year, it just makes sense to get it right at the beginning.