Two Step's Private Company Equity Management Blog

As noted in my recent blog posts, helping busy CFO's learn how to generate the disclosure requirements of FAS 123R (now ASC Topic 718) and the two prior steps described below (valuation and amortization) reminds me a little of watching my one-year old son learn to take one step at a time. Because the primary goal of equity compensation reporting is creating the requisite financial statement disclosures, let's continue with the third and final step a typical, privately-held, venture-backed company needs to understand to properly report equity compensation expense related to "plain vanilla" stock option grants. In case you are more advanced, please note that this article addresses the basics of FAS 123R.

For background reference, note the previous blog articles Part 1 and Part 2 of this 3-part series:

1. Part 1: Valuation and Black-Scholes Variables
2. Part 2: Expensing Stock Options
3. Part 3: FAS 123R Reporting Disclosures

Learning to Walk - Reporting the Expense and Related Disclosures

Now that we've learned to generate the fair value of an option grant using the Black-Scholes formula and how to amortize the fair value of an option grant over the requisite service period, we are now able to generate the requisite financial statement disclosures.

When working with plain-vanilla option grants, at a minimum, you will need to report these disclosures relating to your option valuation and expensing. These disclosures are now described in detail in ASC Topic 718-10-50. Under FAS 123R, you would find this information in Paragraph A240.

When looking at these disclosures, I like to break it down into three sections.

Section 1 - Valuation Summary

For the options granted in the current reporting period, you need to disclose the "range" and "weighted average" values for certain variables used in the Black-Scholes formula: volatility, interest rate, expected term, and dividend rate.

1. Range - To determine the range for each variable, you need to disclose the lowest value and highest value used for each. For instance, if a 20% volatility was the lowest value you used when determining fair value for the options granted in the reporting period and a 30% volatility was the highest value for the same period, the range you would disclose would be 20%-30%.
2. Weighted Average - To determine the weighted average for each variable, you need to "weight" each variable based on the number of shares granted at each value. The total number of shares granted is then divided by the sum of the weights to end up at the weighted average. For instance, if there is one grant for 1,000 shares with a 25% volatility and another grant for 500 shares with a 30% volatility, the weighted average volatility would be: (25*1,000) + (30*500)/1,500 = 26.67%.

When you disclose the range and weighted average values for each of the four Black-Scholes variables (volatility, interest rate, expected term, and dividend rate), as well as the range and weighted average values for fair value per share, you will be disclosing a total of 10 values in the valuation summary section.

Section 2 - Option Activity

For option activity in the current reporting period, you need to disclose the number of options outstanding at the beginning of the period, the option activity during the period, and several numbers related to the end of the period. The requisite disclosures breakdown as follows:

1. Total Outstanding at the start of the period - This is the total number of options outstanding as of the beginning of the period. If the reporting period is 1/1/2009 - 12/31/2009, this is the total number of options outstanding at the end of the day on 12/31/2008. The number outstanding at the start of the period will be: Total Granted - Exercises - Forfeitures - Expirations.
2. Grants during the period - This is the total number of options granted during the period, even if those grants were cancelled during the period.
3. Exercises during the period - This is the total number of options exercised during the period.
4. Forfeitures during the period - This is the total number of options cancelled during the period prior to vesting.
5. Expirations during the period - This is the total number of options cancelled during the period that were vested.
6. Total Outstanding at end of the period - This is the total number of options outstanding at the end of the period. The Total Outstanding at the end of the period is: Total Outstanding (at start) + Grants - Exercises - Forfeitures - Expirations.
7. Total Exercisable at end of the period - This is the total number of options that are exercisable at the end of the period. The Total Exercisable at the end of the period is: the number of options that have vested - the number of options that have been exercised for outstanding option grants.
8. Total Unvested at end of the period - This is the total number of options that have not yet vested at the end of the period. The Total Unvested at end of the period is: the number of outstanding options less the number of those options that have vested.
9. Total Vested or Expected to Vest at end of the period - The Total Vested or Expected to Vest at end of the period is: the sum of the number vested + the number expected to vest.

1. Grants during the period - The number vested = the number that are exercisable at the end of the period (Item 7 above). You don't use the number "vested" here, because it is possible that a portion of the vested shares have been exercised. You want to look only at the number of vested shares that can be exercised at the end of the period.
2. Exercises during the period - The number "expected to vest" is the number that is "projected to vest" at the end of the period. This value is the number of shares that are outstanding but have not yet vested at the end of the period (Item 8 above) after applying the annualized forfeiture rate, as described in the Part 2 article that discusses how to expense option grants.

For each of these nine disclosures, you also need to disclose the weighted average exercise price. For example, if there was an option granted for 1,000 shares at an exercise price of $2 and another option granted for 1,000 shares at an exercise price of $3 during the year, the weighted average exercise price for the number granted during the period (Item 2 above) would be: (1,000*2) + (1,000*3)/2000 = $2.5. Therefore, for each of these disclosures, you need to look at each individual grant, exercise, or cancellation that goes into the calculation and calculate the weighted average exercise price. A standard formula for weighted average exercise price for each item above could be expressed: (SUM(Disclosure Item for that grant * Exercise Price for that grant) for all option grants used in the Disclosure Item)/SUM of that Disclosure Item.

For disclosures 6-9, you also need to disclose the weighted average remaining contract term. For this calculation, you must first determine the remaining contract term for each option and then apply a weighted average based on the number of shares. The remaining contract term is calculated for each option by taking the number of days left between the reporting period end date and the date of expiration for that grant and dividing by 365 (because the value is disclosed as a number of years). A standard formula for weighted average remaining contract term for each item above could be expressed: (SUM(Disclosure Item for that grant * Remaining Contract Term for that grant) for all option grants used in the Disclosure Item)/SUM of that Disclosure Item.

For disclosures 6-9, you may also need to disclose the aggregate intrinsic value. Intrinsic value is the difference between the fair market value at the end of the reporting period and the exercise price of the option. Aggregate intrinsic value is the total of the intrinsic value for all the options included in the calculation for the disclosure item for the current reporting period. This value is not always required for privately-held companies because for many the fair market value changes infrequently. However, if you have the data, you may choose to include it. A standard formula for aggregate intrinsic value for each item above could be expressed: SUM(Disclosure Item * (Fair Market Value on Reporting Period End Date - Exercise Price for that Grant)) for all option grants used in the Disclosure Item. For instance, assume the fair market value of an option on the reporting period end date is $3. Then, assume there is an option grant for 1,000 shares outstanding at an exercise price of $2 and another option grant for 500 options outstanding at an exercise price of $1. The aggregate intrinsic value would be calculated: (1,000 * ($3 - $2)) + (500 * ($3 - $1)) = $2,000.

Section 3 - Expense Recognition

When reporting your expense, at a minimum, you should report the following information:

1. Projected Fair Value - This is the total amount of expense expected to be recognized. This includes everything expensed to date, the amount being expensed in the current period, and the amount to be expensed in future periods.
2. Expense Reported - This is the amount of expense recognized prior to the beginning of the current reporting period.
3. Projected Expense - This is the amount of expense that you expect to recognize in the current period based on the amortization schedule at the beginning of the period or at grant date (if the option was granted during the current period).
4. True-Up Amount - If you are recognizing a "true-up" during the current period, then this is the total credit or debit being reported in the current reporting period.
5. Expense to Report - This is the total amount of expense being recognized as equity compensation expense in the current reporting period. This would be: Projected Expense + True-Up Amount.
6. Total Reported Expense - This is the total amount of expense that has now been recognized through the end of the current reporting period. This would be: Expense Reported + Expense to Report.
7. Remaining Expense (otherwise known as Unrecognized Compensation) - This is the amount left to expense over the remaining service period after the current reporting period. This would be: Projected Fair Value - Total Reported Expense.
8. Weighted Average Period to Recognize Unrecognized Compensation - This disclosure is an estimate of the amount of time it will take to fully expense the remaining amount of unrecognized equity compensation expense. To calculate the remaining period left to expense all option grants, you take the number of months from the current reporting period end date for each option grant * the unrecognized expense for that future period. The sum of this value for all grants is then divided by the total unrecognized expense. This will be the weighted average period left to recognize the unrecognized equity compensation expense. Note that this disclosure should be reported based on a number or years, such as 2.25 years. If you would like to see a sample of how I determine this number in Excel, please email me at jwright@twostep.com.

These are the minimum required disclosures for plain-vanilla stock option grants related to equity compensation reporting for non-public companies. Your audit firm may require additional disclosures. In addition, I did not cover disclosures required for restricted stock or disclosures that are not related to stock options. If there are other items that you have questions about, please let us know.

I hope that this series on valuation, expensing and disclosures under FAS 123R (now ASC Topic 718) has helped you understand the basic steps related to this very complicated task. There are many interconnected pieces to determining the calculations, variables, expensing and reporting. That is why it is often difficult to do all these steps using multiple related spreadsheets.

If you are interested in seeing how a consolidated online equity management system can make it much easier to generate these disclosures, watch the four minute video Introduction to Equity Focus. Let us know if you think our system might make this work easier, more accurate, and save time.

As noted in my recent blog post FAS 123R: You Have to Crawl Before You Can Walk - Part 1, helping busy CFO's generate the disclosure requirements of FAS 123R (now ASC Topic 718) reminded me a little of watching my one year old learn to walk and the three step process described below. With the goal of creating the requisite financial statement disclosures, I'll now continue with Part 2 of the three steps a typical privately held, venture-backed company needs to understand for equity compensation reporting of plain vanilla option grants. In case you are more advanced, please note that this article addresses the basics of FAS 123R.

1. Part 1: Learn to Roll Over - Value the option grants
2. Part 2: Learn to Crawl - Expense the option grants
3. Part 3: Learn to Walk - Report the expense and related disclosures

Learn to Crawl - Expensing the Option Grant

In part 1 of this blog series, we reviewed how to generate the fair value of an option grant using the Black-Scholes calculation. That was the easy part. Now, we will use the fair value per share and amortize it over the requisite service period.

In order to understand how to amortize the fair value, you first need to understand the eight items listed below. Using them, you will choose an expensing method and amortize the fair value of the requisite service period. You will then use this amortization schedule to generate the expense for each reporting period. For each reporting period, you may also need to "true-up" the expense being reported, as described below. When expensing your options, keep in mind one of FASB's guiding principles: At any point in time, you must have expensed the pro rata portion of the fair value based on the portion of the option that has vested.

1. Fair Value Per Share: This is the value of the option calculated based on the Black-Scholes formula.
2. Actual Fair Value: Fair Value Per Share x Number Granted = Actual Fair Value. This value is the total amount we will expense for this option over its service period if the employee does not terminate before the option is fully vested.
3. Requisite Service Period: This is the time period over which you will expense the option grant. When dealing with plain vanilla option grants, this is based on the period the option vests. For example, if the option's vesting schedule is 25% per year for 4 years, the requisite service period for this option is 4 years.
4. Forfeiture Rate: This is a projected annual rate that you expect options to be forfeited in the future. Forfeited means options which are cancelled before they vest. It does not include options that expire, meaning options that are cancelled after they vest. This rate is used to discount the amount of the actual fair value that is expensed in each reporting period. Private companies with little or no historical employee forfeiture data may need to look to a comparable rate, such as the turnover rate at peer companies to determine a reasonable forfeiture rate (until you have your own sufficient historical data to use).
5. Reporting Period: This is the time period in which you will report your expense. For example, if the company reports annually and the fiscal year end is 12/31, the reporting period for 2009 is 1/1/2009 - 12/31/2009.
6. Expensing Method: You are able to calculate the amortization schedule for an option grant using one of the following three methods. Each of these methods use the forfeiture rate to discount (or "haircut") the Actual Fair Value.

1. Straight-Line: The straight-line expensing method is where you divide the projected fair value by the number of days in the requisite service period. Using this method expenses the same amount in each reporting period. The problem with using the straight-line method is that under many vesting schedules, you may not satisfy the requirement referred to above of expensing at least the portion of the fair value as the option has vested to date.
2. FIN 28 (Accelerated Method): The accelerated expensing method treats each vesting tranche as a separate amortization period from grant date to vest date. This results in the expense being front-loaded, since expense from each vesting period is taken in the current reporting period. Although this typically satisfies the FASB requirement referred to above of expensing at least the portion of the fair value as the option has vested to date, it can have what some companies consider the negative impact of a much greater expense being taken in earlier years and a much lower expense in later years.
3. Modified Straight-Line: The modified straight-line expensing method (which I recommend) is based on the straight-line expensing method, but adjusts for the requirement that you need to recognize at least the portion of the fair value as the option has vested to date. This results in a slightly higher expense in earlier periods, but ensures that you take enough expense under both graded and front-loaded option vesting schedules.
   
   Regardless of which method you use, if an option fully vests, you end up taking the same amount of expense over the entire service period.

7. Projected Fair Value: The actual amount expected to be expensed each period is called the Projected Fair Value which is the Actual Fair Value reduced by the forfeiture rate. This value is generated through the creation of the amortization schedule.
8. True-Up: At each reporting period, you can consider running a "true-up" of projected fair value based on actual forfeitures and actual vesting events. When adjusting for a true-up using the modified straight-line method, you recalculate the amortization schedule to determine how much should be expensed at the end of that reporting period. This adjustment results in:

1. A credit entry for any expense taken for any options forfeited during the reporting period (options cancelled prior to vesting).
2. A debit entry for any employees still with the company to account for (a) the amount that actually vested during the reporting period and (b) a portion of the next vesting tranche that is more likely to vest.

If you determined a reasonably accurate projected forfeiture rate, the true-up amount should typically be immaterial. If it is not, you should consider adjusting the forfeiture rate you use going forward. Also, keep in mind that when an option fully vests, you end up expensing the actual fair value for that grant regardless of the forfeiture rate you selected.

Just like when my one year old first started to crawl, it takes some assistance and a little trial and error before you understand how to generate an option's amortization schedule. It is a complicated process and this short article is only able to provide an overview of the basics. The complexity in the process is the reason that so many companies turn to a more automated system that involves less management and manipulation of complex spreadsheets.

To see how an integrated equity management system can bring together stock plan administration, FAS 123R reporting, and equity compliance, sign up for a demonstration of Two Step Software's online equity management system, Equity Focus.

If you have not yet read Part 1 on valuation, you may find it helpful. Otherwise, Part 3 will be posted shortly that discusses how to generate the financial statement disclosures of FAS 123R.

If you have any questions, feel free to contact me at jwright@twostep.com or post them in the comments below. If there are any areas where you would like more information, please let me know.

Recently, my one-year-old started to walk and watching him do this for the first time was amazing. As I watched him over the past year learn how to roll over, and then crawl, and then walk, I realized that learning how to walk is very difficult. In a similar way, as I have helped clients with FAS 123R reporting (now ASC Topic 718) over the past three years, I've realized that learning FAS 123R is also very difficult.

As discussed in my blog post 5 Ways to Perform Year-End Equity Management and FAS 123R Work Faster, busy CFO's want to learn to "walk" as quickly as possible, so they can easily generate the company's FAS 123R disclosures. Unfortunately, if you are new to FAS 123R, you need to learn to "crawl" before you can learn to walk. With the goal of creating the financial statement disclosures, I'll cover three areas a typical privately held, venture-backed company needs to learn to value, expense and report plain vanilla option grants. I'm not going to get into complicated definitions for any of these. Instead, I'm going to stick to the FAS 123R basics to help you take the first few steps toward understanding FAS 123R better (using my son's first few steps as the metaphor):

1. Learn to Roll Over - Value the option grants
2. Learn to Crawl - Expense the option grants
3. Learn to Walk - Report the expense and required disclosures

Learn to Roll Over - Valuing the Option Grant

The first and most basic building block you need as part of generating your FAS 123R disclosures is to value each stock option grant. Private companies will use the Black-Scholes model to calculate the fair value of their option grants. In order to calculate the fair value, you will need the following six variables. While an equity management system can do all of the FAS 123R calculations work for you, it is still important to understand how the FAS 123R disclosures are generated.

1. Fair Market Value - This is the value of your underlying stock on the date of grant and is typically determined as part of a 409A valuation.
2. Exercise Price - This is typically the same as your FMV.
3. Expected Term - You need to calculate your expected term. There are several ways to do this, but assuming you are a private company with little historical information, FASB gives us a formula under SAB 107, as extended by SAB 110.
   
   The formula is: (Weighted Average Vesting + Contract Term)/2.

• Contract Term: This is simply the life of the grant. If it is a 10-year grant, then contract term = 10. If it is a 7-year grant, then contract term = 7.
• Weighted Average Vesting: This measures the amount of time from date of grant to each vesting tranche and weighs it based on the number of shares vesting. I've included a sample of this in Two Step Software's set of free Black-Scholes Calculators.

4. Interest Rate - In order to determine the interest rate to use for your option grant, you need to do the following:

1. Go to the Federal Reserve Board site and download the Treasury Constant Maturities.
2. This gives you forward looking rates for 1, 2, 3, 5, 7 and 10 years.
3. Match the expected term you generated to the year. That gives you the interest rate to use in your Black-Scholes calculation. If your expected term is 5, use the 5 year rate. If your expected term is 6, you need to average the rates for years 5 and 7 to get the appropriate rate for 6 years.

5. Volatility - In order to determine your historical volatility, you need to do the following:

1. Determine your company's set of public peer companies.
2. Download the stock prices for each of the peer companies by entering their stock symbol at Yahoo Finance.
3. Enter these stock symbols into a volatility calculator. You can download Two Step Software's free FAS 123R volatility calculator.
4. Enter the expected term.
5. You now have a volatility that can be used in calculating fair value using Black-Scholes.

6. Dividend Rate - A typical private company does not distribute dividends, so this is normally 0.

As soon as you have all of these inputs, you can plug the values into the Black-Scholes formula to come up with the fair value per share for an option grant.

Complicated? Yes, I know. But to help you out, I've included an Excel spreadsheet-based calculator as part of our Black-Scholes Calculators below that you can use with the variables we drilled down on above to generate your fair value per share using the Black-Scholes calculation.

Download Two Step Software's set of free Black-Scholes Calculators for help in generating your weighted-average vesting term, volatility, interest rate, and fair value per share.

In the future, if you want to avoid the hassle of doing all these calculations for your option grants using spreadsheets, take a look at a demo of Two Step Software's consolidated, online equity management system. 

Check back next week to learn how to "crawl" before you "walk" and see how to expense the fair value of the option grant over the requisite service period.

And if you have any questions about the FAS 123R variables, feel free to contact me or post them to the comments below.

I was at a law firm the other day listening to three attorneys debate whether their spreadsheets were a satisfactory tool for doing their transactional clients' capitalization tables. The first attorney (we'll call her Susan) said that her spreadsheets were fine. Her stock plan administration worksheets rolled up automatically into a few other worksheets for a client's capitalization tables and those worksheets could show the data by class, type, date, and fully-diluted.

It all sounded very complicated, but I was impressed. The next attorney (we'll call her Ann) said that her spreadsheets could track the stock and option data, but could not display it by date in the past or in the future. Also, her spreadsheets could not handle option vesting schedules. The third attorney (“Eric”) asked if Ann used the same spreadsheet templates as Susan. Ann said that her spreadsheets were similar to Susan's, but with some variations. Eric admitted that he’s basically a spreadsheet novice.

The reason we were discussing capitalization tables is that they are critical decision-making tools for CFOs, investors, board members, attorneys and clients – and they need to be 100% accurate. Anything less is bound to make someone look very bad. Sometimes the problem is as simple as two people with two different versions of the same stock issuance or option grant data.

As the innocent bystander in this rousing discussion, I commented that it sounded like everyone was doing the record tracking and corresponding capitalization tables slightly differently. Then I suggested they consider an online, consolidated system for stock plan administration – for five pretty compelling reasons:

1. Centralize and Share Data: If data needed for capitalization tables is in one place – rather than in multiple copies of spreadsheets – there are fewer discrepancies. Centralized online data can also be shared more easily.
2. Simplify Data Entry: Data can be entered more accurately if all you have to think about is point-and-click. It means less typing and no tedious copying and pasting.
3. Automate Calculations and Reports: A computer-based system will never make a mistake, no matter how difficult the calculation.
4. Increase Standardization and Best Practices: If everyone is doing tasks the same way, you have the ability to set best practice standards and ensure consistency enterprise-wide.
5. Connect Data to Documents and Accounting: In a consolidated system, it is much easier to link related stock plan administration data and documents, such as Board minutes to option grants or grant data to complex FAS 123R reporting.

Susan objected only when I mentioned that a centralized system would reduce the risk of errors. She insisted that her capitalization tables were accurate. And while I had no reason to doubt that, I asked whether her spreadsheets could handle changes in the preferred stock conversion ratios, for instance, or a stock split. Susan replied with an emphatic “yes." She explained that she just copied and pasted the new ratio down the entire column and the next cell generated the updated calculation.

I told Susan that this was precisely where errors happen. In fact, I saw a reference recently to a KPMG report that suggested the vast majority of operating spreadsheets used in financial reporting contain material errors – which is consistent with what we hear from CFOs every day. Even when they have not yet encountered problems, these CFOs say that they are ever-fearful that their resident “spreadsheet guru” might leave (and take their ability to use complex and connected spreadsheets with them).

It's not that spreadsheets are bad or can't handle complex calculations. Of course they can. It's just that the standardization and simplification benefits of an online stock plan administration application are overwhelming. This is particularly true when you consider many different people, using many different spreadsheets, to track many different equity transactions, for many different companies that each have complex capital structures. The risk that an error may creep into the process and flow through the entire system is tremendously high. Another benefit of a web-based system is the opportunity to save money by redirecting routine tasks to a lesser-skilled and lower-cost person.

The next time you're working with complicated spreadsheets for your stock plan administration and capitalization tables, consider this: What if you could simplify, standardize, and centralize the work while creating a process that costs less and increases accuracy? When you're ready to stop worrying about hidden errors or copying the right numbers into the right cell, take a look at Two Step's Equity Focus system to find out what an online, consolidated equity management application could do for you. After all, you have far more important things to worry about these days.

As I was starting to write the first part of my new blog series: Five Ways to Perform Year-End Equity Management and FAS 123R Reporting Faster, I received an email from a new customer who recounted a conversation he imagined between him and his auditor. It was timely because it set out nicely how an equity management system would make year-end FAS 123R reporting faster and save audit fees.

Mr. Auditor*: How did you come up with a discount rate of X% and volatility of Y%?

Controller*: It was actually done by our FAS 123R reporting system, Equity Focus, using Yahoo closing price data for the selected peer companies and interest rates from the Federal Reserve site.

Mr. Auditor: How do I know I can trust your numbers? Got any back up showing how you came up with the discount rate and volatility?

Controller: Here's a report that sets out all of the discount rates used by period and stock closing prices for the selected companies by day for the expected term period, as well as the formulas used to derive the volatility. Have fun. Now leave me alone.

*Names have been changed to protect the guilty.

That hypothetical conversation when the same equity management system is used to do all of the stock plan administration and FAS 123R disclosures is short and sweet. It illustrates why using a consolidated system decreases the time a FAS 123R audit takes. The auditor asks the questions that need to be asked when doing a FAS 123R audit in order to get the back-up data for the assumptions. The Controller or CFO can quickly provide the auditor with all of the back-up information with just a click of a button. That can only be done if you're using an automated equity management system.

Now, let's compare that "happy" conversation to a "sad" one I imagine a lot of private companies have with their auditors if they're still using Excel spreadsheets.

Mr. Auditor*: How did you come up with a discount rate of X% and volatility of Y%?

Controller*: I had to go to Yahoo Finance to download the closing prices for each of my peer companies. Then, I went to the Federal Reserve site to download the interest rates. I then did these crazy calculations and used them to generate my fair value. Here are my spreadsheets showing the fair value calculations and expense for the period.

Mr. Auditor: How do I know I can trust your numbers? Got any back up showing how you came up with the discount rate and volatility?

Controller: (Sound of papers rustling and mouse buttons clicking in the background) I can't find the back up information. I may have misplaced it after using the variables in my calculations. Trust me. I followed all the steps we discussed last year to generate those values.

Mr. Auditor: That's not going to cut it. I need to see exactly how you came up with those variables. You'll need to do them again before I can accept your disclosures.

Does that sound vaguely familiar? If so, that's exactly why an equity management system should be used to generate your FAS 123R disclosures and turn that frown into a smile.

If you have a similar story, I encourage you to share your experience in the comments.

Download our FAS 123R Productivity Kit for more information on how you can get your FAS 123R reporting done faster, better, and save audit fees.

As the founder of Two Step Software, I've been asked numerous times how to simplify the many complex aspects of equity management. When we developed our online system 15 years ago, our goal was to use a database application to make the equity management and reporting process easier, faster and more accurate. And as we continue to work with new customers and listen to their challenges, we often come back to the same three-part framework that can be used create a solid foundation for anyone involved in this type of work. The basic framework consists of the following:

1. Capitalization
2. Equity Accounting
3. Compliance and Documentation

Now, let's take a brief look at each of these areas individually.

A. Capitalization

Capitalization means tracking who owns the company and what they each own. The capital structure may consist of many different types of ownership instruments, such as common stock, preferred stock, options, warrants, restricted stock, and convertible notes. Each equity instrument is held by different types of owners, such as founders, management, employees, investors, lenders, and partners.

The three basic components of capitalization tracking are:

1. Stock plan administration: The basic tracking of each type of ownership instrument and who owns it.
2. Equity transactions: Ownership changes occur over time for many reasons such as initial issuances or grants, transfers, vesting, exercises, employee terminations, restrictions lapsing, death, and divorce.
3. Fully-diluted capitalization tables: There are many ways to report the capitalization of a company, but there are a few common formats which generally are based on types of ownership or who the owners are (by person or group). A common way to report the total ownership of a company is to look across all of the different types of ownership and break it down to the simplest level which is known as "common equivalents."

Ownership record tracking is the foundation for accurate equity management. If it’s not 100% correct, any errors or inconsistencies will lead to costly mistakes that will get magnified over time.

B. Equity Accounting

Equity accounting is an exercise to determine what number should be reported for equity compensation expense in the income statement for the period. Until FAS 123R (which came about in Dec. 2004), many venture-backed, non-public companies typically reported no equity compensation expense for stock options granted at fair market value. Under FAS 123R, this is no longer permitted. Now, privately-held companies that report in accordance with GAAP or are being audited must include an equity compensation expense amount, even for ISOs.

The three basic components of equity accounting are (using the example of stock options):

1. Valuation: FAS 123R requires a company to determine the "fair value" of a stock option granted to an employee using an accepted valuation formula such as Black-Scholes. Its variables include: exercise price, FMV, expected term, volatility, risk-free interest rate, and dividend rate.
2. Expense determination: FAS 123R mandates that a company recognize the cost of equity-based compensation over the related "service period" (usually the vesting period). It also requires the use of an expected forfeiture rate and periodic "true-ups" to account for the fact that a portion of options may never vest.
3. Financial statement disclosures: Paragraphs 64, 65, and A240 of FAS 123R describe the disclosure objectives and minimum disclosure requirements. Examples of these disclosures include: range of variables used for calculating fair value; weighted-average values for fair value, exercise prices, and remaining term; options exercisable at the end of the period; and unvested options at the end of the period.

C. Compliance and Documentation

Too many companies fail to think about good compliance and documentation in advance. Instead, they wait until someone needs something they can't find—and that’s usually the auditor as the audit is being wrapped up or an attorney doing due diligence for an important transaction.

The three basic components of compliance and documentation are:

1. Legal compliance: Every time equity is given out, it involves a legal process, such as memos to the compensation or option committee, board or committee votes, delivering option grants and stock certificates, and notices to employees. Many of these tasks can be performed by someone in legal or finance, but the process should be established ahead of time and documented with legal sign-off.
2. Legal documentation: On the legal side, you need to track copies of each legal action, legal notice, or agreement. These documents should be tracked in the system that you are using for equity management with documents linked to the corresponding records.
3. Accounting documentation: On the accounting side, your system should be able to track and report how each number was determined and any supporting documents. This could involve reconciliation of options outstanding, exercised or vested; variables used in the Black-Scholes formula; or amounts expensed in each period. When an auditor wants to see the backup detail, it should be easy to pull from the system, avoiding extra effort and wasted time.

Fit the Pieces Together and Save (Time and Money)

To be successful at equity management, you must fit all the pieces of the puzzle together. You can't leave out one piece or ignore its importance. Do it right and you’ll drive down one of the high-cost areas of corporate accounting for any venture-backed company. Equity management and accounting can be expensive and time-consuming since it normally involves costly legal and audit resources.

Optimizing these three aspects of your equity management means bringing all of the information and tracking into a single, consolidated system that the entire team—across finance, legal and audit—can use for their particular requirements. When you do, you can finally get rid of all those complicated spreadsheets and get your work done faster and better than you ever thought possible.

Download our FAS 123R Productivity Kit to find out how to simplify your equity management and FAS 123R reporting.

In a recent blog post, I discussed a webinar I attended from Stock & Option Solutions relating to five common mistakes made in year-end equity management work and a few automation secrets that can be used to avoid them. I summarized what I learned as follows:

• Those responsible for the stock plan administration and equity compensation reporting will save time and prevent mistakes if they move from spreadsheets to an automated equity management system.
• Stock plan administrators, controllers, and accountants should start focusing on year-end reporting now to avoid rushing to do all of this critical work in December and January which will only lead to holding up the audit.

These two lessons inspired me to write a short series on how an equity management system can be used to automate stock plan administration and FAS 123R reporting. This blog series will discuss five important tasks you can do better and faster if you move from spreadsheets to a single, consolidated equity management system.

1. Generate disclosures required by FAS 123R
2. Generate fully-diluted capitalization tables
3. Print stock certificates without errors
4. Prepare Section 6039 notices for employees
5. Reconcile data using built-in reports and stored documentation

My first bonus tip to get this series started comes from an item mentioned in the SOS webinar and is something you can do right away. The presenters mentioned that if you use an equity management software system, you should contact your vendor to upgrade to the most recent version of the software. My tip is that anyone using spreadsheets should look to use a software-as-a-service (SaaS) system. When you use a SaaS system, all software upgrades are done automatically for you. While I still recommend contacting your vendor to discuss any recent changes to the software, remember, a SaaS system will cut out one more item from your to do list.

In addition to my offering these suggestions, I would love to hear ways that others have used automation to make their year-end equity management easier. If you have used Equity Focus, Corporate Focus, or another system to get things done faster, please leave your comments below.

Sign up for a live Equity Focus demonstration to see how an equity management system can help you work faster.

With less than four months remaining before year end, I recently attended a webinar hosted by Stock & Option Solutions on taking the pain out of year-end equity management and reporting. The webinar went through five common mistakes made in year-end planning and the most effective "automation" secrets to avoid them. This was an excellent webinar that any stock plan administrator or equity compensation professional should view.

In summary, their list of the five most common mistakes made by stock plan administrators in the year-end equity management process include:

1. "Failure to restock the toolbox" - meaning forgetting to review the tools at your disposal and your internal processes until the very end of the year
2. Making tax mistakes - such as forgetting to send out 6039 notices to participants who exercised incentive stock options during the year
3. Making mistakes with disqualifying dispositions - such as not accounting for terminated employees
4. Not communicating effectively with plan participants - such as not getting the information to the participants in a timely manner
5. Forgetting to prep for 2010 - meaning you finish your 2009 work, but you don't proactively look at the work needed in 2010. For example, did you check to make sure you had plenty of shares in your plan for 2010?

The automation secrets that were discussed included the following suggestions:

1. Stop using spreadsheets (or at least improve the use)
2. Use mail merge and other tools to send out electronic notices
3. Automate reconciliations
4. Record webcasts for employee education
5. Upgrade to the most recent version of your software tool and talk to your vendor about any changes in the software

With all of us trying to be more productive as equity management staffs are shrinking, these automation suggestions will save countless hours and actually produce better and more accurate results. We've summarized Two Step's tips for year-end reporting in a white paper entitled: A Five Step Framework to Create Auditable Stock Option Records and Comply with FAS 123R.

My two primary takeaways from this webinar are:

1. If you're still using spreadsheets for stock plan administration work, consider moving to an automated system to save time and prevent mistakes.
2. Don't wait until the end of the year to start thinking about of all of the year-end tasks and reporting. Halloween and Thanksgiving are around the corner and all of a sudden we'll be in 2010.

Again, I highly recommend that anyone involved in end of the year stock plan administration watch the Stock & Option Solutions webinar and then think of just a few things you can do today to improve your year-end equity management and reporting. I guarantee the investment of time will pay handsome dividends in your short and long term equity management practices. At the time of this writing, the materials for the presentation are available, but the recording is not.

An outsourced CFO called me the other day. He said he’d heard about how easy it was do to FAS 123R equity compensation accounting in Corporate Focus—and he was anxious to get started. His high-tech client was actually being sold or refinanced the following week, and he needed to provide updated financial statements in accordance with GAAP. Because the company had not been tracking its equity compensation expense over the past few years, this involved updating the compensation line items.

This tech company had originally been using its law firm—one of the top West Coast firms—to track its stockholder records. Later, when the stock option plan was created and the company still had fewer than 50 employees, the law firm continued to track the option grants, vesting schedules and employee terminations using Corporate Focus, based on information provided by the company or based on the board minutes prepared by the law firm. 

At first, I happily told the CFO that accomplishing his goal was simple—he could just log into Corporate Focus and update the valuation and amortization variables that had not been tracked by the law firm, such as volatility, interest rate, and forfeiture rate. Once the variables were updated for each batch of option grants, he could then calculate how much equity-related expense needed to be included in the income statement for each annual reporting period, because the financial statements were being recreated anyway.

However, when I looked up the law firm in our tech support system, two things became apparent: a) they were an older customer and had not yet transitioned to our hosted platform for Corporate Focus; and b) they hadn’t updated their software in over a year and were about three releases behind. Without the latest updates, the equity accounting calculations would not be the most current, meaning that the CFO would not be able to take advantage of the system’s robust equity accounting features.

When I explained this to the CFO, there was an uncomfortable lull in our conversation. He was shocked and frustrated to discover that his client’s law firm was so many versions behind in Corporate Focus—and that they would not be able to schedule an upgrade on their internal systems for at least a week. Because the transaction had to be completed in the next seven days, there was just no time to spare. 

At that point, the CFO’s only option was to have the firm's paralegal provide their client’s information in the form of Excel spreadsheets. He would then have to manually move the data over to internal spreadsheets which he used for their other clients. Lastly, he would have to wade through the tedious process of determining the valuation for each grant and then the amount to expense for each reporting period. 

Unfortunately for the CFO and his client, walking through the necessary calculations would take about 30 hours of work over the next seven days—instead of just a few hours if he could have used Corporate Focus to do them. The end result was a huge waste of time, not to mention the additional legal fees related to sending all of the data to the outsourced CFO—and then of course the additional accounting fees to do the actual work. In 20/20 hindsight, this all could have been easily avoided had the law firm kept its software up-to-date or if the firm had been using Two Step's hosted platform. In either case, the client’s CFO would have been able to log in and execute his FAS 123R calculations in no time at all.

Law firms can easily avoid finding themselves in this undesirable situation if they regularly upgrade their systems or move to their software provider's hosted platform, which is always on the latest release. 

Will your firm be ready the next time a client calls with a request? If you’re unsure of the answer, you need to check out Corporate Hygiene: It's Like Brushing Your Teeth, But With a Different Kind of Payoff. This real-life story is a superb illustration of how intelligently managing your client data can go a long way in making a positive and lasting impression—with existing clients, potential clients and others who really matter. 

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, because 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 into 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.