The Overlap of FAS 123R and Sec. 409A in the Stock Option Valuation Game

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Although option expensing under FAS 123R caused a great amount of confusion when it was first introduced, fortunately, stock plan administration systems were able to handle much of the difficult leg work. That's clearly not the case when it comes to common stock valuation and the overlap between FAS 123R and Sec. 409A where the old methods (i.e. discount to the last round of financing) are no longer acceptable.

John Hancock, a securities attorney with Foley Hoag LLP in Boston, advises financial executives that if they are a CFO or controller, "They have to be extremely well versed in 123R and 409A." Why? Because although FAS 123R and Sec. 409A both address the valuation of options, the details of the rules differ in significant ways.

The Internal Revenue Service requires a "fair market value" approach under Section 409A and provides specific safe harbors for valuing the common stock underlying employee stock options of privately-held companies. If a stock option with standard time-based vesting does not satisfy the requirements of Sec. 409A because it is granted at a discount to fair market value, the IRS imposes significant penalties. The Financial Accounting Standards Board, which governs GAAP financial reporting standards, requires a "fair value" approach to valuation and recommends use of the AICPA practice aid entitled "Valuation of Privately-Held Company Equity Securities Issued as Compensation."

Although it sounds simple, Dan Kossmann, the Chief Financial Officer of Initiate Systems, Inc., refers to FAS 123R as "an administrative nightmare." Kossmann, who has used Two Step Software's tool called Equity Focus to help automate stock option administration and reporting at his last two companies because it consolidates capitalization information and the documents related to valuation, said: "I don't know how larger companies can do it without implementing a software system."

Scott Goodwin, a partner at Wolf & Company in Boston, echoes that point suggesting that, "The key is to hire an outside consultant to help with valuation and also use sophisticated software to accumulate the data on the options, calculate their fair value and identify what the expense should be currently and in future periods."

This was Part 2 of a 3-page white paper. Coming next time… Part 3 – "Recommendations for Winning The Stock Option Valuation Game." Or read the full article now at - "The Stock Option Valuation Game"

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


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