Recommendations for Winning the Stock Option Valuation Game

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With the transitional period for Section 409A ending on December 31, 2008, now is the time for organizations to review their equity compensation reporting practices and correct any oversights. Such action will help to avoid the onerous penalties of Sec. 409A and prevent them from thwarting your next critical financial transaction. Miss this last chance and you may find that you’re the one getting whacked.

Companies have started to pay more attention to valuation ever since FAS 123R option expensing became mandatory. To provide more supportable results, companies need to document and create procedures for granting stock options that satisfy both valuation and backdating concerns. Then, use an independent third party to provide a written report on the fair market value of the company’s common stock that satisfies the requirements of both the FASB and the IRS.

Despite the costs, the lower perception of bias and a more trusted outside methodology will provide a better result and potentially less scrutiny. Scott Goodwin, a partner at Wolf & Company in Boston, noticed, “After layering on the 409A requirements, investors pushed almost all of their VC-backed companies to get formal valuations to get a more accurate stock valuation for tax purposes and to feed into their FAS 123R reports.”

In the end, there’s no substitute for actually documenting a company’s internal controls over stock option granting and reporting procedures. Auditors are now required to evaluate a non-public company’s internal controls over financial reporting. Under Statement on Auditing Standards No. 112, they must report to management and “those charged with governance” any material weaknesses in internal controls which would include those related to equity compensation accounts.

Since equity compensation accounts are considered “non-standard” accounts, they will receive greater scrutiny. “Companies should take responsibility for documenting and establishing an appropriate internal control system and not view this as an exercise in just satisfying their auditors because management is ultimately responsible for it,” advises Goodwin.

If companies do not pay attention to valuation and stock option backdating, auditors, acquirers, and regulators will discover these issues. That discovery is certain to magnify problems that could have been fixed. The result will be financial and tax issues for both the company and its employees. When a company motivates with incentive equity compensation, the last thing it wants to do is frustrate its team with unnecessary financial or tax headaches that could have been prevented.

Dan Kossmann, the Chief Financial Officer of Initiate Systems, Inc., recalls that stock option compliance was not historically considered a finance function, but was rather a legal or human resources matter. Regulatory complexities have, however, changed the rules of the game and placed accountability with the CFO.

When a company inadvertently grants stock options to its employees below fair market value or is deficient in its reporting, it may be “game over” for the management team. Play by the reporting rules and you and your organization can dramatically increase your chances of winning the stock option valuation game.

This was Part 3 of a 3-page white paper. Read the full article now at http://www.twostep.com/news/whitepapers.asp - “The Stock Option Valuation Game"

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

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