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 FAS 123R 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.