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Evolving rules around fair value, complex Sarbanes-Oxley requirements and employment laws, increasing pay-for-performance programs, and the dynamism of fluctuating stock values can turn a poorly organized equity compensation program into a significant business risk.
As the economy comes back, that risk is increasing. Consider these examples:
• Visionary entrepreneurs can often be terrible at record keeping. As they start companies and hire new employees by offering them stock options and other equity compensation instruments, they don’t always keep the best records to track the options issued. Regularly, the options granted are tracked on an Excel spreadsheet that evolves (or devolves) over time into something that can’t be easily audited. When the time comes for an acquisition or IPO, the deal can be delayed or killed due to the lack of visibility over these options.
• A company could face unexpected taxes and penalties if it has been granting options for several years but has undervalued its stock and granted options below their fair market value. The company will get the bad news when its equity is evaluated during due diligence for an investment or acquisition, or in preparing an S-1 filing, or worse, during a tax audit.
A well-run equity compensation program is critical to provide the desired employee incentives. Both regulators and investors keep a close eye on the numbers, where the standards and rules are designed to promote fairness and reduce risk to investors.
The problem is that many companies are still using cumbersome spreadsheets to track their equity compensation programs. The financial executives of those companies should rethink this process. As a company grows—organically, through acquisitions, or from a liquidity event—its value fluctuates and eligible employees turn over, so it makes sense that stock compensation programs must be regularly reviewed and recalibrated. The more a company can automate this process, the more its risk of running afoul of regulators and investors is reduced.
New, relatively inexpensive cloud-based tools are available that integrate valuing and expensing equity compensation, corporate tax, dilution, and disclosure requirements. These tools optimize the administration of an equity compensation program though automation and greater accuracy. Timely recalibration and maintenance of equity compensation programs is vital to steering clear of investors and regulators who may protest or cite a company for violations.
Trends Impacting Incentive Compensation
Despite some positive trends, the economy and stock market remain volatile, and many companies’ stock option programs are hampered by the fact that shares remain underwater, meaning that the strike or grant price is currently lower than the stock’s fair value. When this occurs, options often need to be modified in order to regain the employee motivation factor, and yet, many companies allow this necessary event to remain on the back burner.
At the same time, many companies are reviewing their executive compensation practices and linking pay with performance. Compensation designs often overlook the realities of implementing and monitoring performance measurement. That’s when advanced tools that can handle tracking, accounting and reporting can take the burden off of staff professionals.
New conditions, such as the fusion of International Financial Reporting Standards with U.S. GAAP, are likely to increase the complexity of stock-based compensation programs in the future, including options, restricted stock awards, and other types of stock compensation. Tax considerations such as tax jurisdiction and reciprocity are a major consideration for companies with international operations. The IRS is beginning to conduct 409A audits, and tax authorities appear to be most interested in companies that do valuations in-house, as opposed to engaging an objective third party to perform the valuation. Additionally, employees are on the move between jobs due to downsizing and other factors, causing forfeitures to rise.
The most important thing that a company using equity as a form of compensation can do is to know its plan and review it often. The dynamism of the markets, your company, and the economy require nearly continuous evaluation and monitoring of your stock compensation programs.
New Cloud-based Tools
The adequacy of controls around the granting, tracking and reporting of stock options is an area where many companies fail to comply. Many young companies or startups still use spreadsheets to track equity compensation. This is a recipe for disaster given the complexity of the equity compensation environment, which is affected by the economy, liquidity events and pay for performance.
That’s why one of the most practical solutions to look into is new cloud-based systems that can help you accurately and efficiently incorporate the necessary changes that all of these variables generate. These tools automate all or most of the activities you would do on a spreadsheet and streamline administration and accounting calculations. They also assist in simplifying cumbersome activities such as updating interest rates.
Cloud-based tools automate the redundant aspects of a program that make spreadsheets complicated, such as monitoring the volatility of peer group companies. If you issue awards monthly, as some larger companies do, you would have to refresh this and other data, but the new cloud tools do much of this work automatically. These tools are secure, and don’t require on-site storage or any other IT resources other than Web access. They are cost-effective and easy to use and set up.
Companies should also utilize third-party valuation experts and combine their expertise with cloud tools that integrate many of the variables that occur during the lifecycle of a business. Staying on top of equity-based compensation by combining professional advice and cloud applications will benefit your company in terms of cost, accuracy and reduced risk of regulatory scrutiny. If your company doesn’t have the in-house resources necessary to remain in full compliance with regulations and education, you should seriously consider cloud-based automation.
For accounting firms, partnering with proven providers of cloud-based equity compensation programs can attract more business to your firm and keep your clients in compliance with the myriad laws and rules pertaining to equity compensation.
Matt Armanino is a partner and COO of Armanino McKenna and manages the firm’s CFO Advisory Services consulting practice. Learn more at www.amllp.com/consulting.