Gary Levine: Capitalization Matters

Are The FAS 123R Storm Clouds Hovering Overhead?

Times read: 169

05/22/08

Capitalization Matters Gary Levine

Gary Levine - The weather has been a bit steamy here in the Boston area. Everyone is talking about the heat and humidity this month … the old “it’s so much worse than dry heat.” Unfortunately, the weather is not that predictable here in New England and it’s not uncommon for the forecasters to make mistakes.

Let’s hope it’s not that way for your spreadsheets.

Does sweat start to bead on your brow when you realize the auditors are coming in next month and you haven’t had time to check and re-check the formulas in your stock option spreadsheets? Or when you try to figure out which is the most recent version of the spreadsheet? Do you get a cold chill when you realize that because of all the new FAS 123R regulations, your auditors are going to be putting your valuation assumptions under greater scrutiny than last year? Have you discussed in advance what they are going to want to see?

Since Financial Accounting Standard (FAS) 123R moved equity compensation expense from a pro forma footnote to a line item in the income statement, CFOs and controllers have felt a storm brewing. I’ve referred to it in other articles as the “Perfect Storm” when thinking about SOX, FAS 123R, option backdating, and new executive compensation disclosures.

Since your goal is to make the annual audit as painless and brief as possible, have you thought about how you are going to put it all together? If it’s your first time, how would you begin to comply with FAS 123R and satisfy the auditors? Well, there are a few general steps that you can take to create auditable stock option records, comply with FAS 123R, and ensure the perfect storm by-passes your next audit.

First, organize all your legal documents. Before anything else, start properly recording and documenting the legal actions of the Board, the company, and each employee as they relate to option grants, exercises, and cancellations. Because your option records and equity compensation expense reports will later reflect these actions and the supporting documents, you want to avoid any inconsistencies that may show up in an audit.

Second, centralize your records. Consider consolidating all transactions that relate to stock option administration, valuation and expensing, and legal compliance in a single, integrated system. This is particularly important as stock option data tends to come from a number of different areas within a company, typically in documents most commonly related to legal, finance, and human resources. When each department retains and manages its own collection of information, it can lead to errors, inconsistencies, and missing documentation – in addition to duplicate effort and wasted time.

Third, automate the transactions. Over the course of hundreds of transactions and many years, the risk of error increases. The best way to reduce potential errors is to let your computer do the work. When you automate, you know you are tracking, calculating, and reporting similar transactions the same way, every time. It saves time and it creates an audit trail showing who made the changes and when. Based on this higher level of reliability, auditors are more comfortable with automated systems and typically can sample fewer records which will save audit time and expense.

Fourth, determine the variables. Now that the new regulations require companies to include stock option-related compensation expense in the income statement, auditors are even more careful when reviewing how each variable used in the valuation model is determined – particularly fair market value, volatility, and expected life. You must be able to document that you followed a reasonable process to determine each variable. If the valuation and expensing variables are properly documented, based on a reasonable process, and supported by an integrated system, it will provide the auditors with greater confidence and raise fewer red flags.

Fifth, prepare your reports. The final and perhaps ultimate goal of stock option administration is to produce a clear and concise set of reports that provide the necessary information for a company’s quarterly and annual financial statements. More specifically, your company will want to prepare a standard set of reports that it can use each quarter to generate the stock option-related expense items. Using the same system for generating both the stock plan administration and valuation and expensing reports will help to avoid inconsistency and increase accuracy. To ensure a smooth audit, prepare the list of reports in advance and organize them in a format that is easy to review.

If you would like a few more details or a visual chart that lays out these actions and describes the documents, click here to read a white paper I recently authored regarding setting up a Framework to Create Auditable Stock Option Records and Comply with FAS 123R.

Gary D. Levine, President and CEO
Two Step Software, Inc.
www.CapitalizationMatters.com


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Your SaaS Provider's Infrastructure: Like Your Own Systems ... On Steroids

Times read: 174

05/19/08

Capitalization Matters Gary Levine

Gary Levine - Talking with hundreds of companies over the past year about our stock plan and corporate governance applications, we've seen the "tectonic shift" that some analysts have referred to with regard to the acceptance of SaaS applications in the business application market. Even Bill Gates has referred to it as a "sea change" that has arrived and the Microsoft Chief Software Architect, Ray Ozzie, has been pushing it as inevitable. Perhaps the change in attitude started with Salesforce.com and Google Apps, with a slight nudge from Youtube, Facebook, and Craig's List, but it has clearly arrived. Having watched the change in attitudes and acceptance from real buyers between the beginning of 2007 and today, I wondered what has accounted for the shift in the acceptance of online applications by somewhat conservative business, financial and legal executives who are generally not technology "early adopters."

The primary impetus is that most internal IT executives, the ones that need to make the decision on whether to sign off on a new SaaS application, now are proponents of hosted applications and agree that in most cases SaaS applications have as good or better systems infrastructure as they could provide for their own internally installed applications. But, what is the cause of their shift in attitudes between 2006 and 2007? Infrastructure improvements.

First, the bar has been raised for the standard offerings from the top hosting providers that now offer a level of reliability, redundancy, security, and data backup that is difficult for a single company to match. Second, the bar has been raised for software application providers so that every enterprise level business application must offer an infrastructure that is properly configured, tested and hosted at a leading hosting provider. There is no longer any excuse for downtime from a SaaS provider of mission critical business applications. Whether you are Salesforce.com, RIM Blackberry, or Two Step Software, customers expect the same standard for service level agreements and zero downtime. Not to say it can't happen despite the highest levels of technology diligence, as we have experienced from almost every one of Two Step's SaaS providers, but every step should be taken to reduce the risk.

There are five basic areas to think about when looking at a SaaS provider:

1. Security: Physical on-premise security; personnel selection; user authentication; and preventing unauthorized access


2. Redundancy: power supplies; internet access; hardware, and failover systems


3. Monitoring: 24/7 application, server, network, and user access


4. Back Up: Daily and intermittent on-site and off-site backups


5. Getting Your Data: Retrieval of data when service ends

For instance, at Two Step Software, we use one of the nation's leading managed hosting providers that offers a zero downtime guarantee and provides a level of physical, operational, and system security that would be difficult for any business to match. (see: http://www.twostep.com/solutions/install_options.asp) It's like your own systems, on steroids with redundant internet access, back-up power supplies, physical and online access security, redundant hardware as well as back up inventory, 24/7 monitoring, and daily data backups.

We believe that once you find an application that satisfies your business requirements, you shouldn't have to worry about the application hosting infrastructure. Let your SaaS provider focus on the details of delivering a reliable and high performance infrastructure so you can focus on your business needs. Although you can't take a walk through your SaaS vendor's hosting location, look for a SaaS provider with an excellent reputation and one that offers a technical infrastructure that you feel is superior to your own. Then, rest easy.

Gary D. Levine, President and CEO
Two Step Software, Inc.
www.CapitalizationMatters.com


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10 Warning Signs It May Be Time to Give Up Spreadsheets

Times read: 355

04/16/08

Capitalization Matters Gary Levine

Gary Levine - At Two Step Software, we sometimes feel like the Good Samaritans hot line when a CFO, Controller, or stock plan administrator tells us confidentially that they think they may have a “spreadsheet problem.” They don’t know who to turn to. They call us, often late at night, since we’re just a warm body at the other end of the line. Someone to talk to. Some don’t even call. They use email. A few … anonymously.

Well, we know what they’re going through and it’s so much more common than they realize. We see it every day, but they think they’re the only one who’s ended up this way. They imagine they’re the last CFO in Silicon Valley who’s afraid to move away from the comfort of their old, trusted Excel spreadsheets. There’s no question that converting to a fully-automated stock plan administration system is a big step. But like so many other important decisions in life, there are classic tell tale signs that it may be the right time.

At Two Step, we use a list of 10 warning signs to determine whether it's time for someone to stop using spreadsheets for stock plan administration:

1. You’re starting to feel pressure from those who care about you (maybe the CFO, General Counsel, or your auditors) to get control of your spreadsheets.


2. You’re no longer proud of your capitalization tables and corporate governance practices.


3. Handling stock option exercises and vesting schedules is starting to get in the way of other work and even family matters.


4. You haven’t been honest with your colleagues about how much time you’ve been spending updating the fully-diluted capitalization tables.


5. You’ve been postponing getting up to speed on FAS 123R and once you even “blacked out” doing a Black-Scholes valuation with a high expected volatility.


6. You’ve exceeded the 100 stock and option record limit.
   
7. You have a dangerous combination of common stock, convertible preferred stock, and stock options.


8. You’re using more than 3 spreadsheets at the same and you can no longer figure out how to calculate the number vested and exercisable at any point in time.


9. You’re required to report your capitalization information to third party stakeholders, such as outside investors, lenders, an insurance company and the Board of Directors.


10. You plan to seek outside financing in the next 12-24 months or your exit strategy includes being acquired by a publicly-held company.

If you answered yes to at least three of those cases, “you have a problem.” It’s not too late to seek help, but it is time to consider moving to a fully-integrated, consolidated, browser-based, stock plan administration system. You’ll not only improve your stock and option tracking, but you’ll be able to automate complex calculations, generate great looking reports that you can be proud of, create fully-diluted capitalization tables in real time, and ease the accounting burden of FAS 123R reporting.

Like so many other major decisions in life, if you postpone for another week, another month, or another year, it will only make the eventual transition even more difficult. As the camera pans around the cheap motel room full of family, friends and co-workers, you hear their voices calling out: “Do it today. You’re a wreck. We’re only looking out for your best interests.”

Gary D. Levine, President and CEO
Two Step Software, Inc.
www.CapitalizationMatters.com



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CFOs Can Be Cool Again: Quickbooks is on Your iPhone

Times read: 548

04/01/08

Capitalization Matters Gary Levine

Gary Levine - When I got a pop-up message from Intuit the other day that they have jumped on the bandwagon and released a read-only version of Quickbooks Online for the iPhone, it got me thinking about cell phones and my new iPhone. It made me realize how pervasive this new productivity tool had become in the nine months since its release. It’s particularly noteworthy, since Quickbooks Online does not yet work with the Apple Safari browser. Although it’s very limited and many will ask was it really worth the effort, I think it’s a great looking view-only application and delivers a minimum amount of information into the palm of your hand. How much is in a bank account? How much do we owe that vendor? How much does this customer owe us today? A balance sheet for Dec. 31st? It’s all there.

But I wondered, are they perhaps just trying to get on the “Mac is cool” bandwagon after seeing the recent onslaught of the square guy v. the cool guy in the Apple v. PC television commercials (http://www.apple.com/getamac/ads/) or have they seen the genuine utility for their user base of a “less is more” iPhone approach to online apps (http://www.apple.com/webapps/).

My own mobile, wireless experience has been that of frequently switching to the latest and greatest cell phone (sometimes I admit more than once a year) until I’ve finally settled down … with an iPhone and “it rocks.” At first, a flip phone seamed so cool compared to the original peanut shaped phones. Then, along came the Razr which was so thin, who could resist. Then, I had to debate a Blackberry versus the Treo when they were still head to head in popularity. I chose the Treo 700w, since I wanted to remain in the Windows family, but learned to regret the choice.

Then, last summer, one of my neighbors was showing me travel photos on his iPhone, “finger flipping” from one picture to another and the totally useless, but cool looking, world clock for the cities he had traveled to. The user experience was contagious, almost like bubonic plague or methamphetamines. I had to have one. BUT, I had to worry about the ATT Wireless Edge network. Everyone claimed it would be like going back to 1998 dial-up for web surfing. Well, I decided I’d just limit my browsing to Wifi access, since by 2007 carrying around a cell phone and an iPod on a bike ride or on an airplane seemed so old fashioned. Two devices? I thought if over one million iPhones had already been sold by Sept. 2007, why not be 1,000,001. Certainly, no one could claim I was the first guy to jump off the bridge.

Six months later, there are over 5 million iPhones in use. In fact, every employee at Two Step Software has been offered an iPhone just so they can experience the direction of new technology (Apple has certainly led on innovation from the original Macintosh to today’s iPod Shuffle - now that’s small). If you’re working at a SaaS model software company on America’s Technology Highway (Route 128), spitting distance from MIT, it’s somewhat obscene to still be carrying around a cell phone, a Palm pilot, an iPod, and a beeper. Get it together!

At the rate that iPhone applications are coming out, it’s becoming the ubiquitous connectivity device for the new business executive, less focused primarily on email and more focused on browsing and other online productivity applications. I use my iPhone for phone calls, emails, text messaging, listening to music, checking the weather, reading NY Times headlines, contact management, scheduling, family photos, my alarm clock, maps and directions, YouTube, secure password management, Salesforce.com, and Quickbooks.

If you too want to be the coolest over 40, Facebook, Myspace, YouTube, Twitter, Blogspot, Gen X, SaaS, on-demand, CFO or CPA and “connect” with those young, hipster 20-something employees slugging down Jolt and cranking out Ajax code, get an iPhone, download a Wagner symphony, and surf the Wall Street Journal Online. They’ll see you rocking out and think you’re watching Sarah Silverman F***ing Matt Damon on YouTube (http://www.youtube.com/watch?v=wnVJZkDuVBM).

Now, that’s cool.

Gary D. Levine, President and CEO
Two Step Software, Inc.
www.CapitalizationMatters.com


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The Trickle Down Effect of Sarbanes on Internal Controls at Venture-Backed Companies

Times read: 419

03/26/08

Capitalization Matters Gary Levine

Gary Levine - At a recent Two Step Software webinar entitled “Lessons Learned in 2007: A Recap of Stock Option Reporting Updates,” more than half the audience of financial executives responded that they had not taken any steps to prepare for the new risk assessment auditing standards that apply to non-public companies (Statement on Auditing Standards 104-111) despite the fact that according to Dan DeVasto, the CEO of Wolf & Company, P.C., these changes to the audit standards are some of the most significant in two decades.

As explained by his partner Scott Goodwin, although non-public companies are not required to provide the same types of certifications and management reports as public companies, since they are not subject to the Sarbanes-Oxley Act, the audit standards by which the internal controls of non-public companies are going to be reviewed are now relatively similar to those of public companies (SAS 104-111 from the AICPA for non-public companies; Auditing Standard 5 from the PCAOB for public companies). In both cases, auditors will be using a COSO type framework to assess whether a company’s internal controls over financial reporting are sufficient and will need to advise the audit committee if they are not. Of course, for a non-public company there is no requirement that the executives provide a Sec. 302 certification, that management provide a Section 404(a) report, or that the auditors provide a Sec. 404(b) opinion (which is not yet required for smaller public companies).

Question: Why are public companies spending significant amounts of money addressing their internal controls to comply with Sec. 404 of SOX and satisfy AS 5 while GAAP reporting venture-backed companies are largely paying little attention to satisfying SAS 104-111, although the exercise that their auditors will be going through evaluating the sufficiency of the internal controls over financial reporting for both types of companies will largely be the same.

Answer: For a non-public company, there is no threat of public embarrassment, lower share price, and criminal penalties for the company and management if they do not satisfy the internal controls requirements. There is only the risk that an audit will take longer, become more costly, and the audit firm will be required to document and communicate any material weaknesses to management and “those charged with governance” (SAS 112).

Let’s Ask: With the impact of SOX clearly being felt by non-public companies already, whether based on pressure and covenants from investors, lenders, insurers, and other stakeholders, is it really necessary to add the threat of criminal sanctions to encourage companies that plan to be acquired by publicly-held companies in the near future to raise the level of their internal controls over financial reporting?

I hope not. Maybe by sufficient education on the benefits that companies receive by adopting good corporate governance and appropriate internal controls over financial reporting, we can avoid “SOX Lite” from becoming mandatory for companies without public investors. Hopefully, instead, sufficient oversight can be provided by audit committees and directors of venture-backed companies that hope to one day become public themselves or be acquired by publicly-held companies. Better internal controls over financial reporting are relevant to any company that is looking to increase its value in the financial marketplace. Every venture-backed company finds this out during the business due diligence process which is eventually when the “rubber meets the road.”

Gary D. Levine, President and CEO
Two Step Software, Inc.
www.CapitalizationMatters.com

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From Fraud to Greed to Oops: Inadvertent Stock Option Backdating

Times read: 470

03/18/08

Capitalization Matters Gary Levine

Gary Levine - One of our speakers at a recent webinar on Compliance, Craig Newfield, General Counsel at Gomez, Inc., aptly used the phrase “from fraud to greed” to explain the transition from the Enron period scandals that brought us the Sarbanes-Oxley Act of 2002 to the executive compensation and option backdating scandals that have brought us CEO resignations and new SEC executive compensation disclosure requirements in 2006. I’ve always thought the unique connection between these two scandals was that almost all of the intentional option backdating ended in 2002 as a result of the expedited Section 16 filing requirements of Sarbanes-Oxley.

However, as a result of Sec. 409A, FAS 123R, and increased scrutiny of equity compensation reporting, we may now have entered a new period where the risks and penalties associated with “inadvertent” stock option backdating, rather than primarily intentional backdating, will become the next “gotcha” for financial executives at both public and privately-held companies with deferred compensation plans, including the most basic forms of stock option plans.

Recently, John Hancock, a corporate partner at the Boston law firm of Foley Hoag LLC, highlighted for an audience of financial executives at a Two Step Software webinar the connection between the end of the transitional rules period for Sec. 409A and on-going stock option backdating scrutiny. The overriding principle is to offer the greatest clarity as possible as to when an option grant occurred by providing written evidence that all steps were taken with respect to an option grant on a specific date.

If there is any uncertainty with respect to the number of shares, the vesting period or the list of recipients, this will increase the likelihood that the option could be considered to be granted on a later date when potentially the fair market value of the stock could be higher, resulting in an option being granted below fair market value. This could convert a qualified option to a non-qualified option, change the financial and tax implications to the employee and the company, and potentially trigger the severe penalties under Sec. 409A that apply to discounted stock options.

As far as practice tips for new stock option grants, his recommendations included:

1. Avoid actions by written consent.


2. Promptly create minutes reflecting board actions and file in minute books.


3. Avoid subsequent changes to the authorization by the Board.


4. Avoid authorizations that suggest there will be future decisions to be made.

Following the SEC Chief Accountant’s September 2006 letter that addressed option granting practices, the IRS making option backdating a Tier 1 issue in June 2007, and the new SEC executive compensation disclosure rules, it is clear that auditors will be giving greater scrutiny to equity compensation reporting and the related back up legal documentation.

With that in mind, every company, public or private, should work on standardizing their stock option granting and administration practices to reduce the risk of option backdating and improve their equity compensation reporting. In addition, companies should adopt appropriate internal controls to insure their policies and procedures are actually being followed. This type of work at the front end will pay big dividends at your next audit, your next financing transaction, or when the company goes public.

Gary D. Levine, President and CEO
Two Step Software, Inc.
www.CapitalizationMatters.com

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Year End Reprieve: SEC Extends Safe Harbor for Estimating Expected Term

Times read: 521

03/12/08

Capitalization Matters Gary Levine

Gary Levine - Are you concerned about estimating your stock option expense because you are a company that has little or no historical exercise data and you thought you’d be losing the simplified method under SAB 107?

If so, you’ve been granted a reprieve by the SEC.

The safe harbor of SAB 107 (released in March 2005) for estimating the expected term for employee stock options has been extended beyond Dec. 31, 2007 by SAB 110, released by the SEC on Dec. 21, 2007.

While most companies are saying thank you, the rest are saying “it’s about time.”  One of the single most asked questions related to using the Black-Scholes formula had been “what were companies with no data to estimate the expected term supposed to do when SAB 107 expired?”  With 10 days to go, the SEC finally responded.

A nice summary is available in the SEC press release at: http://www.sec.gov/news/press/2007/2007-267.htm

As a result of SAB 110, eligible companies, both public and privately-held, are able to continue to use the simplified method under SAB 107 for estimating expected term if their own historical experience isn't sufficient to provide a reasonable basis for such an estimate.

As stated in Release 2007-267:

Specifically, SAB 107 provided a simple rule for estimating the expected term of what it called a "plain vanilla" option: it would be just the average of the time to vesting and the full term of the option. Companies could use this simplified method until Dec. 31, 2007. The new assistance that is being issued today, SAB 110, extends the opportunity to use the simplified method beyond Dec. 31, 2007.

The Interpretive Response section of SAB 110 states:

… the staff understands that an entity that is unable to rely on its historical exercise data may find that certain alternative information, such as exercise data relating to employees of other companies, is not easily obtainable. As such, some companies may encounter difficulties in making a refined estimate of expected term. Accordingly, if a company concludes that its historical share option exercise experience does not provide a reasonable basis upon which to estimate expected term, the staff will accept the following "simplified" method for "plain vanilla" options consistent with those in the fact set above: expected term = ((vesting term + original contractual term) / 2) …” Note: the Staff uses a weighted-average formula for “vesting term.”

At the same time, the SEC has modified its previous position and now only permits the use of the SAB 107 method if the “company does not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term.” In the past, a company could have used the simplified method even if it had a greater amount of historical exercise data.

The SEC explained that at the time that SAB 107 was released, it had expected that historical information about employee exercise behavior from other companies, such as actuarial studies, would soon be readily available. This was the basis for the statement in SAB No. 107 that the staff would not expect a company to use the simplified method after Dec. 31, 2007. Since such information is not yet available, the Staff removed the deadline.  It is likely that once such data is available, the SEC may again prohibit the use of the SAB 107 simplified method.

SAB 110 is available on the SEC Web site at: http://www.sec.gov/interps/account/sab110.htm

Gary D. Levine, President and CEO
Two Step Software, Inc.
www.CapitalizationMatters.com


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