Two Step's Private Company Equity Management Blog

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.

I recently came across a great blog for start-ups and venture capital companies, called Altgate. It’s written by Furqan Nazeeri, who is an Entrepreneur-in-Residence with Softbank Capital of Newton, MA. He talks about “Startups, Venture Capital & Everything In Between.” His short articles are practical, useful and easy to read. I’m a big fan, not because he recommends our software, but because if you’re someone like me, a CEO or CFO or an entrepreneurial, high-tech company with very little time, you will find it useful.

Furqan helps Softbank evaluate and source investment opportunities, works with Softbank portfolio companies, has been a key person in a number of startups, and is continually searching for the next opportunity. In the process of researching equity compensation for startups, he came across Two Step’s Equity Focus stock option management software.

He was so intrigued by the product claims of being an easier way to manage options and create capitalization tables that he called Two Step and asked for a demonstration. His opinion: “I was very impressed. … In the past I have used shrink wrapped, desktop software to manage options, as well as just Excel files and shared directories. I think Equity Focus is superior to both.”

Here’s his unsolicited review which you can read on his blog.

The solution is delivered as a service like Salesforce.com and provides an easy to use yet very sophisticated tool to create and manage your company's capitalization table. It allows you to create a comprehensive archive of all the events and related documents that influence your cap table and it provides an audit trail.  The reporting looks very powerful and the pre-built work flow and forms are comprehensive and flexible enough for most startups.

And to boot, it is priced very reasonable - cheap enough, in fact, that every startup should use this tool or one like it from inception.

My unsolicited review of Altgate: Don’t just read his blog. Trust him one step further. Read the blogs he reads. I do.

Are you struggling with the challenges brought on by Financial Accounting Statement 123(R)?  If you are, you’re not alone.

How would you like your concerns about the future of stock option plans to be heard by influential leaders in the stock plan market?  I'd like to give you that chance.

This month I'll be participating in an important event discussing the future of share plans in a global economy.  The First Annual Global Shares Leadership Forum will be held in West Cork, Ireland from June 22-24, 2007 - to coincide with the Global Equity Organization (GEO) Conference being held in London that week.  The event has attracted a top notch group of stock option professionals from the U.S., Europe, and Asia.  The special guest speaker is Corey Rosen, Executive Director of the National Center for Employee Ownership. 

The host of the event, Global Shares, Plc., is bringing together a powerhouse group of 40 influential leaders within the stock plan market from around the world to discuss the global challenges of business and employment practices created by new public company oversight requirements, revised stock option expensing regulations, stock option backdating scandals, and executive compensation reform.

Senior executives will attend from well known organizations like Citigroup Inc., Fidelity Stock Plan Services, Deloitte, Intel Corporation, Merrill Lynch & Co., Inc., Morgan Stanley, Charles Schwab & Co., Inc., Baker and McKenzie, and KPMG International are expected to participate.  The sponsors of the Leadership Forum include: Buck Consultants, iComp LLC, IFG Group PLC, Sungard, and Orrick Herrington and Sutcliff LLP. 

As Global Shares CEO Carine Schneider said in a recent press release, "With the number of regulatory changes in the past few years, particularly in the US and the EU markets and the growth in Asia, the need to bring together a select group of industry leaders and create a unique forum for those who are expected to set the trends and standards in the near future became quite apparent."

I am continually working with non-public companies struggling to manage stock plan and corporate governance information in order to supply systems that will make their compliance easier and help their audits go smoothly.  As the President of Two Step Software, I invite you to share your concerns with me.  After all, the latest regulatory developments will affect share plans and corporate governance practices for organizations around the world - and that includes your organization.

What challenges do you face because of stock option administration concerns and new FAS 123R requirements? Click here to let me know and I'll bring your concerns to the Global Shares Leadership Forum or if you respond after that event, to another forum down the road.  Thanks in advance for your contribution.