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 because your work is not over. The grace period for
IRS Section 409A is coming to an end on December 31, 2008 and ongoing FAS123R 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.