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:
- Equity Accounting
- Compliance and Documentation
Now, let's take a brief look at each of these areas individually.
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:
- Stock plan administration: The basic tracking of each type of ownership instrument and who owns it.
- 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.
- 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):
- 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.
- 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.
- 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:
- 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.
- 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.
- 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.