Capitalization Matters

Corporate Hygiene: It's Kind of Like Brushing Your Teeth, But with a Different Kind of Payoff

Let me ask you a question: Do you brush your teeth every day? Or just the week before a dental check up? 

Imagine if the only time your teeth were brushed was twice a year at the dentist. It wouldn't be a very pleasant visit (not that they ever are, actually). Well, that's the situation too many law firm clients find themselves in when they’re ready for a corporate event or transaction. Right before a financing or annual meeting, everyone rushes around in a mad dash looking for documents and updating capitalization tables. Why? Because the records haven’t been updated or organized since the last mad dash. 

But if you're a corporate client at Pierce Atwood, LLP in Portland, Maine, the frenzied scene described above is a long-ago memory. I recently sat down with Chris Howard, the head of the firm’s business practice group. He explained to me that with the firm’s centralized client information management system (CIMS), Corporate Focus, the corporate records for all of their business clients are organized, minute book documents scanned, and capitalization tables up-to-date. 

As the largest New England law firm North of Boston, Pierce Atwood has over 1,000 corporate clients who can depend on having their information and documents just one click away when they call. In fact, Chris told me that some of their clients have direct online access to their own information in Corporate Focus on a read-only basis, which eliminates the need for these clients to even contact the firm. This saves the clients legal fees, offers them more flexibility in searching, and of course saves boatloads of time since they can get to their data around the clock. 

As Chris bluntly put it, clients don't usually choose a firm because they practice outstanding “corporate hygiene.” But when an important transaction is pending, these clients notice and appreciate the level of service and risk management that Pierce Atwood provides—whether they need it or not. It's just how the firm does business. And it's the right way to do business.

Chris also noted that it's not really a matter of what technology you have at a law firm, because many firms have implemented state-of-the-art systems and applications in recent years. What’s important is how you use this technology for your clients' benefit. Depending on which client you talk to, those benefits might involve faster turnaround times, lower legal costs, or 24/7 access to legal records. But any way you slice it, when clients see this kind of productivity in action, it doesn’t escape their attention.

In fact, Pierce Atwood’s efforts to help clients help themselves—through a firm-wide CIMS—have enhanced its reputation in the legal marketplace. As Chris explained to me, trust, reputation, and client service are what make a law firm successful—and it’s these qualities that lead to satisfied clients telling other companies about their positive experience. Corporate Focus also makes practicing law easier for Pierce Atwood attorneys, because they can spend more time and energy on legal advice and negotiation and less on administrative requirements. 

Do many law firms use Corporate Focus or have access to systems like Corporate Focus? Of course.  Does it take unusual rigor and tenacity to implement a firm-wide client information management system as Pierce Atwood has done? Absolutely. Do their clients appreciate the benefit when they're ready for their next transaction? You bet. Just ask any of them.  

Then ask your corporate practice group: Do you practice corporate hygiene for your clients on a regular basis—or just the week before a major transaction? Ask them which their clients would prefer. Then ask their Board or investors.

Can Law Firms Really Simplify FAS 123R Reporting for CFO Clients? Think One Shared System.

Corporations depend on their CFOs to report "the numbers" each period. But what happens when these numbers are based on data that’s being tracked at the company's law firm—instead of internally? 

When a company is initially formed, all of the legal and ownership records tend to be maintained by their law firm because, frankly, it's just easier. Over time, the organization begins to grow, and as it does, the complexity of its capital structure tends to grow as well. For example, as an enterprise gets its first round of angel or venture capital financing, it may issue convertible preferred stock and warrants and adopt an employee stock option plan.

The complexity typically relates to the company's capitalization table, its stock plan administration, and the reporting of equity compensation expense under FAS 123R. Each year or quarter, the CFO must determine—in addition to how much was paid in cash compensation and benefits to the company's employees—how much compensation was paid to employees who have stock options or other equity compensation.

The Current Approach No Longer Makes Sense

Although stock plan administration work can be outsourced by a company to its law firm, the equity compensation reporting normally isn’t, since it involves accounting work. And so, at the end of each year, it has been common practice for paralegals to send reports and spreadsheets to CFO clients who need to calculate their stock option related expense. The CFOs then take the information provided, add it to their own internal spreadsheets, and run the numbers for the period.

The problem? This typical approach has proven to be very difficult, time-consuming and error-prone. The challenge is that the data is being updated by the law firm while the accounting calculation that uses the data is being done by the company—each in their own separate system or set of spreadsheets. An uncoordinated system and a virtual recipe for disaster.

The Solution? One Consolidated System.

The solution is to bring the stock plan administration being done by the law firm and the equity compensation reporting being done by the CFO together seamlessly in a single, consolidated system. In this way, everyone is using the same set of live data and the information is real-time, accurate, and consistent. No time is wasted sending reports and spreadsheets back and forth while manually updating information that is being tracked and reported by one side or the other.

Here’s how this integrated approach works: At audit time, the CFO logs in to the stock plan administration and equity compensation reporting system that has been used by the paralegal at the law firm throughout the year. The CFO knows that all required changes for the year have been updated, since he or she has had access to the information all year and has updated the valuation variables on an ongoing basis. 

To calculate the amount of equity compensation expense for the current period, the CFO simply presses a button or opens a report. Because the same formulas are used consistently throughout the system for every record and across each period for the expense calculation, as well as for the required financial statement disclosures, the CFO can be confident that it is 100% accurate.

Whether the consolidated system is at the law firm, at the client’s office, or somewhere in between is immaterial. What’s important is that everyone is using the same system. All parties can log in and work on the areas that are relevant to them, and everyone can see the data live and report on the information as their needs require. 

A single system for stock plan administration and equity compensation reporting ensures that data is reviewed and kept up-to-date over the course of the reporting period. And because all of the information is already in the system well before the end of the reporting period, it avoids the typical mad rush at audit time. 

Does this sound like a better method? It is. Does it sound too easy to be true? It's not. Many law firms and CFOs are already using this approach—and they're thrilled with the results. What a difference it can make at audit time (not to mention everybody’s stress levels). It's just a matter of working together.

Printing Stock Certificates? Here’s One Simple Way to Make Your Life (Much) Easier

In the past few weeks, I’ve met two corporate paralegals who have been using our product, Corporate Focus, to track minute book and capitalization information for many years. Because they’re each tracking upwards of 1,000 client companies for their firms, they keep pretty busy.

We estimate that paralegals like these have tracked more than 1 million stock certificates for privately-held companies in our system over the past decade. But despite the obvious improvements in efficiency that Corporate Focus has made possible, I still have one small pet peeve: The amount of time, energy and client fees that are wasted on stock certificate printing. And in the current environment where legal staffs are smaller and clients are going over outside counsel bills with a fine-tooth comb, every minute counts. 

So when these paralegals told me that each stock certificate they print for a new company uses a "blank" stock certificate form instead of a "pre-printed" stock certificate form, it made me realize that law firms can make small changes that yield big benefits for everyone involved. It may seem like a minor thing—the difference between a stock certificate that just has a border (or standard eagle design) as compared to one that also has pre-printed text and lines. But, when you're the one responsible for printing hundreds or even thousands of certificates each year under the pressure of a deal closing or a FedEx pick up, it matters. Because if the partner or client notices that the numeric text is crooked or misspelled on the certificate for 255,715 shares for which the investor just paid $2.5 million, everything just comes to a screeching halt.

With different printer drivers, assorted printer models, and varying cuts on every printed batch, there is just no way to make every single stock certificate identical. The only way to get it right without wasting precious time is by printing to a blank stock certificate form. With a blank form, there is no need to coordinate names and numeric text with pre-printed lines, because you print the lines and text simultaneously with the stockholder information.

As one paralegal told me, when you've completed your 25-to-1 reverse stock split in Corporate Focus and all the numbers come out right, you don't want to spend extra hours printing the 200-300 stock certificates that now need to be re-issued.  She also told me that at their firm, they no longer adopt a specific form of stock certificate in the by-laws or minutes when they are forming a new company. That means that if they need to change the form to a new style for cost or efficiency reasons, there is no extra legal action required that creates unnecessary legal work or fees. Talk about great client focus.

Now, if you think this is just minutiae that lawyers and paralegals obsess about in their spare time, imagine the next time you have to mark down a legal bill because it took two hours to print 26 common stock certificates (making you late for dinner and behind on your more important legal work). Wouldn't the client have been much happier if they'd been billed merely 20 minutes to "just print a few certificates," as they see it?

Then, take another look at the difference between the "border only" certificates, the "blank eagle" certificates, and the dreaded "pre-printed" forms of the same. These are all available from any stock certificate printer (such as Goes Lithograph or Corpex). It's just a matter of choosing how efficient and productive you want to be—for yourself, and for your clients.

Catch the Wave: Client Data is Becoming Cloud-Bound

Over the past 30 days, I came across four articles that made me sense a shift in the air regarding online access to legal client data. Collectively, these pieces focused on a trend that’s sweeping the corporate landscape: Realizing the tremendous productivity and client service benefits—and the fact that email, laced with inefficiency and security issues, simply isn’t cutting it anymore—lawyers are finally getting comfortable with the idea of their confidential client data being stored somewhere outside the four walls of the firm.

Fortunately, it seems that this comfort level is starting to jive with available technology—and the small current is becoming a wave.

At Two Step Software, where we track online minute book information for over 150,000 client companies, virtually all of our new law firm customers over the past few years have stored their client data at our hosting facility. Why? Because our hosted solution offers better performance, greater security (i.e., biometric checks, 24/7 surveillance, and diesel generators for power outages), and vastly reduced support costs (no upgrades, no in-house servers). The hackneyed phrase "better, faster, cheaper" comes to mind.

As discussed in these articles, the objections of yesteryear regarding online client data no longer carry the day. Imagine when all of your client information is online and available to you and your clients 24/7—whether you're in the office, at a board meeting, or on a "so-called" vacation.

In March, a law firm blog posted the question What about an online minute book? The writer’s comments were:

"Don’t you think it would be nice if you could do corporation minutes online? And keep them in an online minute book? Instead of keeping them in a 3 ring notebook? Well, I do. I dream of it. Minutes in the cloud. I’d type them up, hit the upload button, and watch them magically appear, organized in chronological order, right there on the web page. The online minute book web page. It would have to be secure, of course. Only those with permission could see them. But they’d be there all the time. Whenever you needed to review them, you’d just click and down they would come from the Internet cloud onto your computer screen. Like rain. Minutes would come from the cloud like rain. Ahh. That would be nice."

Later that month, the International Legal Technology Association (ILTA) published their March 2009 White Paper issue, which included an article I wrote entitled: Client Intelligence: Answering the Call for Greater Productivity. It discusses the numerous productivity benefits—for both lawyers and their clients—of a centralized information repository for client information and documents.

A week later, Brett Burney wrote the article "Storing Your Firm's Data in the Cloud" in the Legal Technology section of Law.com. In it, he acknowledges lawyers’ past reluctance to store client data outside of the firm, while stating that today's online storage usually involves "a server-class machine, probably in an ultra-safe bunker." Burney notes the common acceptance of "deal room" data centers such as those offered by Intralinks, DataSite or Firmex, which have proven their superior security compared to traditional conference rooms.

A few days later, in the blog Compliance Building, Doug Cornelius wrote a post entitled "Extranets for Law Firm and Client Collaboration - Moving Beyond Email" where he discusses some of the challenges of deciding on the right extranet platform. Cornelius made the point that email no longer counts as "collaboration" in the Sharepoint, Web 2.0 world.

These are just a sampling of the growing number of articles that are discussing the topic of moving client data “to the cloud.” Where does your firm stand on the issue? If you're not doing it yet, maybe it's time to explore the brave new world—and the big benefits—of online client data ... one cap table, one minute book, one client at a time. 
 

Funding and Innovation: Is the Chain Broken?

I recently attended an event at the MIT Media Lab sponsored by TheFunded.com, a social networking website geared toward CEOs and founders of start-up companies who want to share war stories of trying to get VC or angel seed funding. 150 CEOs and start-up founders were invited to attend. (I showed up because many of these companies use our product Equity Focus or their law firm uses our product Corporate Focus to track their capitalization after their first VC round or when they create an employee stock option plan.)

The first speaker was Adeo Ressi, the founding member of TheFunded.com, and also a Board member of the X Prize Foundation. The other speaker was Steve Murray, a partner at the venture capital firm Softbank Capital.
 
It struck me as ironic that the presentation was being held at the MIT Media Lab—but while the speakers were talking, I looked down to check a website that was being discussed on my iPhone and saw that I had "No Service." No public WiFi service at an MIT auditorium? Scandalous.  
 
The actual presentation felt a little like being in a Dr. Dolittle book and riding the famous "Pushmi-Pullyu." A group of start-up technology entrepreneurs looking for seed funding had been invited to the pinnacle of technology innovation, but the focus of most of the presentation was on "the death" of early-stage financing for technology companies.

Ressi explained that in the current economic environment, angels have become risk-averse and are spending their time watching their falling stock portfolios and stashing their money under their mattresses. Venture investors are raising less from their limited partners with little or no exit alternatives in the public or corporate markets and spending most of their time and money on saving the best of their existing portfolio investments. 

The best sources of funding at the moment, according to Ressi, are the old-fashioned methods of bootstrapping, vendor financing and customer financing. The silver lining? It’s much cheaper these days to start a new technology venture (assuming it's not a capital-intensive biotech or chip design firm) with Open Source code, virtual development teams, and Web 2.0 marketing techniques. 

Murray explained that Softbank is still funding great early-stage companies, but that unless every check box is checked, the deal will not go through. The risks they could afford to take in the past are no longer acceptable. Most of their money is going to add-on investments for the "already funded" or existing portfolio companies.

Ressi and Murray both agreed that the "the funding model is broken," since without liquidity, there is no sustainable funding model. To his credit, Ressi did try to boost the attendees’ spirits by offering free beer after the presentation, but it would have taken quite a few cold ones after this sobering presentation. 

I was disappointed, having hoped there would be something new or different offered in this exciting venue. Then, after listening to these two pessimistic views from these seasoned veterans, we were invited to tour the projects that were on display at the MIT Media Lab. That experience alone was worth the price of admission. While they were all cutting-edge and pushing the limits of reality, I was most interested in the Cities Project where I ended up spending an hour talking to a doctoral student, Ryan Chin. 

The Cities Project spans the vehicle spectrum from car to moped to bicycle. The CityCar is a stackable, electric-powered, two-passenger vehicle designed for shared one-way transportation in densely populated urban areas. Think SmartCar meets ZipCar. The power and steering mechanisms are built in to the four wheels so there is no engine block or drive train.

This efficient technology has been extended to the RoboScooter which is a lightweight, folding electric Vespa-like scooter. Finally, there is the GreenWheel which offers an electric rear wheel that can be added to any existing bicycle. It will go about 25 miles on electric power and is controlled by the wireless, Bluetooth handlebar throttle. 

Being in the midst of some of the most exciting innovations on the planet, Chin was optimistic about the future and plans to have the GreenWheel in commercial production next year. He mentioned that the CEO of A123 Systems, a Watertown, MA-based company and another MIT nano-tech spin-off that is providing the battery to the Chevy Volt, would be stopping by the following day. All of these vehicles use batteries from A123 Systems which, in the context of this presentation, it should be noted has funding from 10 top-shelf investors and over 1,000 employees from 10 countries.    
 
So, at its conclusion, this evening left me with many questions. Is technology innovation going to screech to a grinding halt since "the funding model is broken?" Will funding be dominated by prize money like the X Prize, which doesn't come close to funding real innovation? Will game-changing ingenuity continue to grow out of leading educational institutions, as did A123, the Internet, Lycos, and FedEx, as well as government agencies, the Defense Department, and NASA? 

Or, will companies that foster incrementally groundbreaking products, such as Google (how we all search), Facebook (how we all connect) and Craigslist (how we find classified advertising), continue to be created in garages, home offices, and now increasingly online teams, bootstrapped once again by credit cards, family and friends, and severance pay?

Despite the stock market meltdown, risk-averse VCs, angels who gave their money to Madoff, and non-existent exit strategies, I am confident that innovation will press on unabated, simply because it's the natural evolution of “Capitalism meets the Geek Squad.” Lucky for us, it just happens.  

The Legal Market Revolution is Happening Today—With or Without You

I'm a big fan of Paul Lippe's legal column for The Am Law Daily called “Welcome to the Future” and have been reading it regularly for the past six months or so. I noticed that the final paragraph of his recent interview with David Baca, chairman of the Seattle-based law firm Davis Wright Tremaine, summarized so much of the buzz that has been going around lately on the potential for real change, death of the billable hour, and profits per partner as a metric—which have all been frequent topics of Paul's, as well as so many other "oracles" of the legal market. (For disclosure purposes, DWT has been a customer of Two Step Software for the past 5 years.)

In Lippe's February 17, 2009 column, “Welcome to the Future: A View from the Left Coast,” Baca offers the following insights:

"There is no question in my mind that technology will upend the legal industry. Clients aren't going to keep paying for information they can get for free online. They will pay for judgment, for talent aggregation, for things that increase their profits or peace of mind. But we're going to have to redefine what our "service" is and how we deliver it. As with all industries that technology has upended, some firms will end up doing really well and some will struggle or cease to exist.

Most law firms, including ours, aren't doing as well as they should using technology to create more value for clients. In most cases, we all haven't felt the same sense of urgency that our clients have. Candidly, the dominance of the billable hour model has meant that there has been very little reason for law firms to innovate or to use technology to enhance efficiency. Moreover, the structure and decision making processes in a large partnership makes change hard and slow. The status quo has been pretty good to most of us. And a lot of firms have wasted a lot of money on technology projects that weren't thought through or properly executed, which makes people more skeptical."

I’d like to highlight parts of Baca's statement that speak to the current upheaval in the legal market and what it foretells:

1) Technology will upend the legal industry. This sentiment has been heralded for many years by practitioners and thought leaders alike. To quote Richard Susskind in an earlier interview with Lippe (in which he calls Susskind "the world's pre-eminent legal futurist"): "In 2000, I was urging lawyers to adopt some exciting technologies which would support the way they worked. Now I am saying lawyers must adapt because new technologies that are coming through are 'disruptive.'”

Susskind predicts that lawyers who are unwilling to adapt will "struggle to survive." We've seen it with records and iTunes; we've seen it with newspapers and digital media; and we’re currently watching it unfold in the auto industry. With the powerful impact of technology on efficiency and choice, it's never a question of whether, but only a question of when.
 
2) Clients will pay for judgment and not information they can get free online. Lippe previously mentioned a business model used by Jeff Carr, the General Counsel at FMC Technologies, which breaks legal services into four categories: counseling, advocacy, content, and process. Carr says that firms excel at the first two categories, but that clients end up paying mostly for content and process because they consume so many hours. 

Lippe explains that since many firms have bundled all four categories, they've been able to overcharge for content and process, "failing to apply the kinds of process and technology innovations that are common among their clients." In better days, this may have been acceptable, but as clients become more savvy and cost-conscious in the economic downturn, they will find alternatives in which they’re paying primarily for the high-value components of legal services: counseling and advocacy.

3) Most firms aren't doing well to create value for clients. Marc Chandler, General Counsel of Cisco, may have said it best: "The greatest vulnerability of the legal industry is a failure to drive models based on value and efficiency and to make information more accessible to clients. The good news is that greater efficiency will create more value for clients. The bad news is that higher levels of efficiency by some raise the bar for others in a competitive market.”

4) The billable hour model has given law firms little reason to innovate or to use technology to enhance efficiency. Increasingly, in-house counsel at major clients have been pressuring law firms to accept alternative, value-based billing methods. Other firms are offering new and innovative ways to lower their hourly rates when it makes business sense. The glacial pace of change may have been dealt an asteroidal blow this past December, when the presiding partner at Cravath Swaine & Moore, Evan Chesler, wrote his "Kill the Billable Hour" article for Forbes magazine. From that point forward, the topic reached the front page of every major business publication and got stuck in the frontal lobe of every CEO and General Counsel nationwide.

5) The structure of law firms makes change hard and slow. As Baca explains, there is something about the decision making process of a large partnership that contributes to slow change. Having worked as a vendor to hundreds of law firms over the past 15 years, I can attest to this. However, lawyers are leaving firms in droves in the current economic market, forced to start new firms and specialized boutiques. These new “high-quality” firms will put pressure on larger firms to change as they tear away just enough business to make an impression.

Don’t Miss the Two Step Webinar on March 3rd

Paul Lippe is the founder and CEO of Legal OnRamp (www.legalonramp.com), a legal online community, and will be one of the featured speakers at a free Two Step Software webinar being held on March 3, 2009, entitled: “Productivity, Service, and Partnership: What They Mean to Your Law Firm's Future.” If you’re looking to understand how marketplace change will affect your law firm’s odds of success or even survival, it will be worth your time to attend.

I also encourage you to be a part of the ongoing discussion by checking out Lippe’s “Welcome to the Future” column and joining Legal OnRamp. The future has a way of sneaking up on you if you’re not paying attention. It's happening now, so get on board—or get left behind.

What If Obama Promised to Mandate Online Legal Records?

A few days before his inauguration, Barack Obama told John King on CNN: 

"Here's the good news ... we have a lot of investment in making the health care system more efficient. Just a simple thing like converting from a paper system to electronic medical records for every single person can drastically reduce costs, drastically reduce medical error, make not only health care more affordable, but also improve its quality." 

When I heard this, I imagined for just a moment that he had said "electronic legal records" instead. For years, law firms and medical practices have been slowly migrating their voluminous paper client records to online systems that can be easily searched, tracked and recalled—whether one is searching for the date of incorporation or the last measles shot.

And “slowly” is the key word here.

Historically, administrators and IT personnel have had a heck of a time getting the highest-paid professionals—doctors and lawyers—to use computers or even type prescriptions and client notes. In fact, the age-old joke is that the worse a doctor’s handwriting is, the better the doctor. (My father and two brothers are doctors and I'm a non-practicing attorney, so I know from whence I speak).

About 5 years ago, I noticed that my dog's veterinarian had all of his doggy records entered in a computer system. Every X-ray, shot, cough, bark, and poop sample was recorded and up-to-date. As the proud parents, my wife and I had online access to our pooch's entire medical history. The same was true for my dentist and for my son's pediatrician. None of them could answer a question without consulting the computer in the examination room.

However, my own physician had to flip tediously through a folder when I asked him a question about last year's physical. And when my wife went in for a procedure that required general anesthesia, the doctors were running around looking for the misplaced three-ring binder containing information on her allergies as well as our consent forms. I was shocked that these reputable practices were still stuck in the dinosaur age of client information management.

Sadly, these same examples apply to 90% of the attorneys in the country, despite the fact that unlike doctors or veterinarians, attorneys are charging $400-$1,000 per hour and can well afford to implement a modern electronic records system.

Having worked with hundreds of law firms over the past decade, I've never heard an attorney disagree with President Obama's basic premise that converting from a paper system to electronic records would drastically reduce costs, reduce errors, and improve service quality. For instance, Philip Beck of Bartlit Beck, The American Lawyer Litigation Boutique of the Year Firm, explains their use of technology: "In the office, we have immediate access to whatever information has been stored on the computers, and we can sort it and analyze it instantaneously, without waiting for help from support personnel."

Yet despite the fact that the benefits of an electronic records system are crystal clear—for law firms and their clients—it’s simply not happening in most mainstream practices today.

So what will ultimately entice these firms to make the switch? The transition process itself takes a good amount of time and effort, even if the actual costs are minimal. Will it be the sagging legal market that is crying out for greater efficiency as firms lay off attorneys and staff? Will it be partners watching profits drop or competition for new clients grow? Will it be clients that are demanding lower legal fees and 21^st-century service capabilities, such as self-service portals and 24/7 access to information? 

Imagine the impact on corporate America's legal bills over the next decade if every in-house counsel, CFO and board member for every venture-backed and public company could find all of their minute books, capitalization tables, contracts, due dates, and invoices online—from anywhere, at any time and without paying a single dollar in legal fees.

I'm just asking all the lawyers in America to think about what their doctor friends are about to be mandated to do—and then think about the millions of paper legal records sitting in their offices, growing more cumbersome by the minute.

It may be a challenge for an industry that has typically been a technology laggard, but in the spirit of change, why not practice a can-do attitude when the next technology project is proposed? Think about the positive impact on your bottom line: "Yes We Can." Think about the greater efficiency and productivity: “Yes We Can.” Think about being able to offer exceptional service to your clients in an increasingly competitive legal environment: "Yes We Can."

Recommendations for Winning the Stock Option Valuation Game

With the transitional period for Section 409A ending on December 31, 2008, now is the time for organizations to review their equity compensation reporting practices and correct any oversights. Such action will help to avoid the onerous penalties of Sec. 409A and prevent them from thwarting your next critical financial transaction. Miss this last chance and you may find that you’re the one getting whacked.

Companies have started to pay more attention to valuation ever since FAS 123R option expensing became mandatory. To provide more supportable results, companies need to document and create procedures for granting stock options that satisfy both valuation and backdating concerns. Then, use an independent third party to provide a written report on the fair market value of the company’s common stock that satisfies the requirements of both the FASB and the IRS.

Despite the costs, the lower perception of bias and a more trusted outside methodology will provide a better result and potentially less scrutiny. Scott Goodwin, a partner at Wolf & Company in Boston, noticed, “After layering on the 409A requirements, investors pushed almost all of their VC-backed companies to get formal valuations to get a more accurate stock valuation for tax purposes and to feed into their FAS 123R reports.”

In the end, there’s no substitute for actually documenting a company’s internal controls over stock option granting and reporting procedures. Auditors are now required to evaluate a non-public company’s internal controls over financial reporting. Under Statement on Auditing Standards No. 112, they must report to management and “those charged with governance” any material weaknesses in internal controls which would include those related to equity compensation accounts.

Since equity compensation accounts are considered “non-standard” accounts, they will receive greater scrutiny. “Companies should take responsibility for documenting and establishing an appropriate internal control system and not view this as an exercise in just satisfying their auditors because management is ultimately responsible for it,” advises Goodwin.

If companies do not pay attention to valuation and stock option backdating, auditors, acquirers, and regulators will discover these issues. That discovery is certain to magnify problems that could have been fixed. The result will be financial and tax issues for both the company and its employees. When a company motivates with incentive equity compensation, the last thing it wants to do is frustrate its team with unnecessary financial or tax headaches that could have been prevented.

Dan Kossmann, the Chief Financial Officer of Initiate Systems, Inc., recalls that stock option compliance was not historically considered a finance function, but was rather a legal or human resources matter. Regulatory complexities have, however, changed the rules of the game and placed accountability with the CFO.

When a company inadvertently grants stock options to its employees below fair market value or is deficient in its reporting, it may be “game over” for the management team. Play by the reporting rules and you and your organization can dramatically increase your chances of winning the stock option valuation game.

This was Part 3 of a 3-page white paper. Read the full article now at http://www.twostep.com/news/whitepapers.asp - “The Stock Option Valuation Game"

The Overlap of FAS 123R and Sec. 409A in the Stock Option Valuation Game

Although option expensing under FAS 123R caused a great amount of confusion when it was first introduced, fortunately, stock plan administration systems were able to handle much of the difficult leg work. That’s clearly not the case when it comes to common stock valuation and the overlap between FAS 123R and Sec. 409A where the old methods (i.e. discount to the last round of financing) are no longer acceptable. 

John Hancock, a securities attorney with Foley Hoag LLP in Boston, advises financial executives that if they are a CFO or controller, “They have to be extremely well versed in 123R and 409A.” Why? Because although FAS 123R and Sec. 409A both address the valuation of options, the details of the rules differ in significant ways.

The Internal Revenue Service requires a “fair market value” approach under Section 409A and provides specific safe harbors for valuing the common stock underlying employee stock options of privately-held companies. If a stock option with standard time-based vesting does not satisfy the requirements of Sec. 409A because it is granted at a discount to fair market value, the IRS imposes significant penalties. The Financial Accounting Standards Board, which governs GAAP financial reporting standards, requires a “fair value” approach to valuation and recommends use of the AICPA practice aid entitled “Valuation of Privately-Held Company Equity Securities Issued as Compensation.”

Although it sounds simple, Dan Kossmann, the Chief Financial Officer of Initiate Systems, Inc., refers to FAS 123R as “an administrative nightmare.” Kossmann, who has used Two Step Software’s tool called Equity Focus to help automate stock option administration and reporting at his last two companies because it consolidates capitalization information and the documents related to valuation, said: “I don’t know how larger companies can do it without implementing a software system.”

Scott Goodwin, a partner at Wolf & Company in Boston, echoes that point suggesting that, “The key is to hire an outside consultant to help with valuation and also use sophisticated software to accumulate the data on the options, calculate their fair value and identify what the expense should be currently and in future periods.”

This was Part 2 of a 3-page white paper. Coming next time… Part 3 – “Recommendations for Winning The Stock Option Valuation Game." Or read the full article now at http://www.twostep.com/news/whitepapers.asp - “The Stock Option Valuation Game"

The Stock Option Valuation Game: Like Whac-A-Mole for Equity Compensation Reporting … Just a Lot Less Fun

This is Part 1 of a three-part series offering excerpts from the Two Step Software white paper, "The Stock Option Valuation Game." You can read the entire 3-page article at http://www.twostep.com/news/whitepapers.asp.

Your 2007 audit may finally be completed, but don’t break out the bubbly just yet ecause your work is not over. The grace period for IRS Section 409A is coming to an end on December 31, 2008 and ongoing FAS 123R and stock option backdating issues must be kept under control. Ignore these complex issues and like that first mole in the game of Whac-a-Mole, the errors will multiply and quickly become out of control. Most likely they will be uncovered at the start of your next financing, when you’re ready to sell the company, or as you prepare to take the company public … talk about bad timing.

If organizations want to stay in control, then they must focus the same amount of attention on stock option valuation as they do to other aspects of their financial reporting. The latest trap for privately-held companies is calculating the fair market value of the common stock that will serve as the exercise price for their employee stock options. The competing guidance under FAS 123R and Sec. 409A makes this a game your organization must win.

Let’s face it, imprecise valuation of the common stock underlying employee stock options is a pervasive problem that venture-backed and other privately-held companies must address. Prior to the new stock option expensing requirements under FAS 123R, the new deferred compensation plan rules under Sec. 409A, and the stock option backdating scandals of 2006, relatively little attention was paid to how a company determined the exercise price of employee stock options. But now, auditors, acquirers, the SEC, and the IRS are laser focused on valuation as it relates to equity compensation. And, they have no intention of losing.

Dan Kossmann, the Chief Financial Officer of Initiate Systems, Inc., knows something about the valuation game, having been the CFO for five organizations that went public, were acquired or received outside financing. He notes that stock option administration and reporting has become a more important part of the CFO’s job because of the focus on financial reporting and expensing by the press, regulatory agencies, board members and auditors. As a result, companies should improve their administrative infrastructures because of the potential exposure.

In fact, he considers the administration of stock option plans an essential financial reporting function, similar to processing payroll taxes. “You have to make sure the I’s are dotted and T’s are crossed because not doing so is now considered a dereliction of duty,” said Kossmann.

Coming next time… Part 2 -- The Impact of Incorrectly Determining Fair Market Value of Equity Compensation Expense.