Two Step's Private Company Equity Management Blog

Earlier this week, I attended an excellent seminar put on by the Boston law firm Foley Hoag LLC on current option backdating issues. Although current SEC investigations into backdating are focused on publicly-held companies and option grants primarily prior to the implementation of Sarbanes-Oxley in 2002, the lessons learned from these backdating schemes apply to the option granting practices for all companies. John Hancock, a corporate partner at Foley Hoag, highlighted a number of practice tips based on the September 19, 2006 letter from Conrad Hewitt, the new Chief Accountant at the SEC. The goal of these practice tips is to insure that the Board of Directors or the Compensation Committee is not inadvertently granting options with grant dates prior to the actual grant date by the Board and in so doing either violating the company’s governance documents or potentially granting discounted options that could give rise to taxes and penalties under Sec. 409A.

To reduce the risk of unintended tax and accounting issues, it is important that every company, public or private, practice good corporate governance in its stock option granting practices. This is critical for venture-backed and other privately-held companies that foresee future financings or acquisitions because option accounting issues are now a standard part of financial due diligence. So, how do you avoid this? The Hewitt letter identifies two stock option granting practices that should be avoided:

1. Option Grants with Administrative Delays – Sec. B of the Letter
2. Uncertainty as to Individual Award Recipients – Sec. D of the Letter

The first relates to how an authorization to grant options is documented and when. It gives examples of how certain aspects of the grants are determined at one point in time, but there is a later step required to finalize the grant. An example would be when a member of management is delegated the authority to determine the option recipients or amounts for each employee, subject to later confirmation by the Board. The second relates to how and when all the granting steps are finalized over a period of time. An example would be where a total number of options such as 100,000 has been authorized for grant by the Board, but the number allocated to each employee may be left up to a member of management to determine after the Board meeting. In each case, the question is to consider is “when all required granting actions” have occurred, although that analysis will be dependent on the facts and circumstances of each case.

Because this is an area that the press has been very focused on over the past year and the Chief Accountant of the SEC has provided written guidance, it is likely that auditors will be reviewing granting procedures during an audit of stock option records and FAS 123R expense recognition. As a result, companies that grant options should take the time to plan in advance and document in writing their specific stock option granting practices and procedures. With a little advance planning and counsel, it should be very easy to avoid any unnecessary ambiguity as to the date of each option grant. In the presentation by Foley Hoag, three practice tips were mentioned that will help to avoid questions concerning the legal date of grant “when all required granting actions” have been completed:

1. Avoid actions by written consent whenever possible, in favor of meetings of the Board or compensation committee with minutes promptly created and added to the company’s corporate records;
2. Avoid any subsequent changes to the authorization by the Board, since this can bring into doubt whether all actions were completed on the original Board meeting date; and
3. Avoid any authorizations that suggest there will be future decisions to be made, since that may indicate either that all actions were not completed at the Board meeting or that there is the possibility of subsequent changes.

If you consider these recommendations when planning your stock option granting practices and procedures, you can reduce the likelihood of inadvertent option backdating or creating a situation where your auditors may determine that the date of grant is unclear. The guidance from the SEC in the Hewitt letter can be extended by reference to non-public companies and help to improve the option granting practices of all companies and reduce the risk of potential tax or accounting issues.

Although we don’t know yet where Paul Sarbanes will end up after leaving the Senate, on Friday, the Wall Street Journal announced that former Congressman Michael Oxley, co-author of the Sarbanes-Oxley Act, would be joining the Ohio based law firm Baker Hostetler LLP. In the firm’s press release, Mr. Oxley said that joining the firm would provide him with a “platform to help companies and investors comprehend the changing landscape of corporate compliance.” I couldn’t help wondering, since Baker Hostetler has been using our product Corporate Focus to manage corporate governance information for its clients since 1999, whether that was one of the primary reasons why Mr. Oxley joined the firm. Would he end up asking tough governance questions in next week’s training class? Would he learn to create cap tables and print stock certificates? Would he view minute books online?

While the Sarbanes-Oxley Act of 2002 was designed to improve financial reporting and transparency for publicly-held companies in the wake of the Enron, Tyco, and Worldcom accounting scandals, it has had far reaching and many positive impacts on corporate governance at all types of companies, including venture-backed, pre-IPO, those being acquired, and most recently non-profit companies. At the same time, it has been highly criticized for its one-size fits all approach that many say has placed an unreasonable burden on small public companies and hurt U.S. capital markets by decreasing the incentive for companies to go public. Hopefully, pressure will continue to fine tune SOX to the point where it continues in a manner where its benefits far outweigh the costs both for large public companies and for the smaller, less well known companies where it may be more important that there remains some level of reasonable regulation.

What’s permeating the Congressional committees for corporate governance and capital markets is a changing of the guard represented by both Senator Sarbanes and Congressman Oxley stepping down at the end of their terms in 2007. Replacing Mr. Oxley as chairman of the House Financial Services Committee is Massachusetts Democrat Barney Frank who introduced legislation as far back as late 2005 to reform executive compensation requiring shareholder approval or at least an advisory vote on executive pay packages. At the end of 2006, the SEC passed new executive compensation disclosure requirements effective immediately for proxy statements in 2007. And all of this is really an outgrowth of stock option expensing reform and last year’s option backdating scandals. But no legislation can succeed without a poster child for the public to sink its teeth into. For corporate accounting fraud, we had characters like Ken Lay of Enron, Bernie Ebbers of Worldcom, or Dennis Kozlowski of Tyco. For executive compensation, the top dog has to be the former Chairman of the NYSE, Charles Grasso, and his $187 million pay package for a non-profit organization. In retrospect, maybe that was a little excessive. In many ways, the accounting fraud that was addressed by Sarbanes-Oxley in 2002 is now maturing into legislation the public can really sink its teeth into since we all get a paycheck and for most of us … it’s not “super-sized.”

As if to emphasize the changing of the guard or is it more like “what comes around goes around,” the other trend reported in today’s WSJ that hints at the end of the Sarbanes-Oxley era and the beginning of something new (or is it new again) is the large number of IPOs for technology companies that are losing money. It reported that all three of the companies that went public this quarter were unprofitable and 62% of the technology companies that have filed for IPOs since January 2005 but have not yet gone public are “in the red.”

After a period of very conservative capital markets where the only excitement has been the gigantic private-equity and hedge fund buyouts, it seems like the public wants in again on the high-octane excitement of trading stocks with fast growing revenues, infinite multiples, and high risk. At least for the moment, the general sentiment is that these newly public companies are still far better than those we were all betting on in the late 90’s. And thanks to SOX, stock option expensing, executive compensation reform and the latest group of watchdogs, we'll know a little more about where all the money's going than we did the last time we had a good time investing our kids college education funds in the stock market.

The Problem: Whether you’ve seen the Academy award-winning film by Al Gore or not, whether you believe in global warning or still doubt the facts, or whether you voted for Bush or Gore in 2000, there’s no question that printing stock certificates is killing us. For publicly-traded companies, stockholders no longer receive paper stock certificates representing their ownership. Instead, an electronic “book entry” is sufficient. Paper stock certificates are no longer required by most state laws. However, for the 99% of all companies that are privately-held, founders, investors and employees still want to be able to feel what they own and that ends up being millions and millions of paper stock certificates. This turns out to be an incredible waste of paper and time. Paper is wasted at an alarming rate because it’s so difficult to print the information from any computer printer exactly on the lines of the pre-printed forms. And because it is so difficult to print them exactly right, it ends up being a huge waste of time. And if you’re paying your law firm to handle your stock certificate printing, it’s also a huge waste of money. Either they charge the client although it took way too long to get it right or they have to write off the time and then they’re not getting paid for it. There’s a great article on this by Janet Wynn, a Managing Director at DTCC.