Two Step's Private Company Equity Management Blog

By polling the audience, we learned that most financial executives are still not comfortable with their processes for FAS 123R compliance.  Most participants indicated they are still using spreadsheets to track their companies’ stock option plans and few feel confident determining the key inputs for the Black-Scholes valuation formula or how to apply forfeiture rates to equity compensation expensing.

Since Spring 2007 was the first audit season after FAS 123R became effective for most calendar year non-public companies, CFOs are starting to appreciate the complexity of the new regulations for the first time.  In the past, less attention was paid to stock option expensing since companies could use the intrinsic value method which permitted the option related expense to be excluded from the income statement, as long as the expense numbers were disclosed in the proforma footnotes.  Now, non-public companies must be more cautious when determining fair market value under the guidance provided by IRC Sec.409A.  They must also use public peer groups to estimate volatility and estimate forfeiture rates when amortizing equity compensation expense. In light of the recent option backdating scandals, more attention is being paid to whether a company has accurate stock option administration documentation and how the FAS 123R assumptions are documented.

The “take away” lessons from the webinar can be summarized as follows:

1. For non-public companies, Black-Scholes continues to be the best method for valuing plain vanilla employee stock options. Typical early-stage, non-public companies do not have the data that would be necessary for a lattice model to be considered a worthwhile valuation alternative (such as information on employee exercise behavior and forfeiture rates).
2. You can determine the fair market value of a company’s stock and the related exercise price for stock option grants in any supportable method that satisfies the reasonableness standard.  The two safe-harbor methods provided by Sec. 409A are: an outside appraisal; or an internal report that meets the “illiquid start-up” requirements.
3. Volatility should be determined by looking at public peer group companies since using zero volatility for non-public companies is no longer permitted.  Sec. 123R discusses the types of information that should be considered when evaluating public peers.
4. You are required under FAS 123R to use estimated forfeiture rate as you amortize equity compensation expense and then “true-up” for actual forfeitures.
5. Auditors are now looking to see that a company has the supporting legal and financial documentation for both stock option grants as well as the FAS 123R data. The best way to insure there are no gaps in the data that could raise red flags is to use an integrated system for stock option administration, valuation and expensing, and managing supporting documentation.

The presentation slides and a recorded version of the presentation are also available from the Two Step web site. 

As companies struggle to get it right during their first audit season under the new regulations, it’s an opportunity to identify those areas where they need to do a better job and consider whether spreadsheets can still offer a reasonable level of compliance and risk management.  It’s clear from the comments we’ve received from many CFOs that auditors are subjecting companies to greater scrutiny if that have not yet moved to more automated, integrated and standardized methods. Why not take the time during the year to review your FAS 123R compliance practices?  It will make it easier for your auditors and for yourself and avoid raising any red flags at audit time that will draw more attention and scrutiny to your stock option accounting numbers.