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:

1. Capitalization


2. Equity Accounting


3. Compliance and Documentation

Now, let's take a brief look at each of these areas individually.

A. Capitalization

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:

1. Stock plan administration: The basic tracking of each type of ownership instrument and who owns it.


2. 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.


3. 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):

1. 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.


2. 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.


3. 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:

1. 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.


2. 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.


3. 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.