Equity Compensation Plan Administration Costsby Achaessa James, CEP
Payroll companies have done a good job of conveying to the business world the complicated nature of administering payroll—tax withholding and payment, tracking sick leave, vacation time, disability leave, etc. Benefits administrators have done a similarly good job of demonstrating the complicated nature of administering other employment benefits, if only by the mountains of paper they distribute several times a year. And because of the obviously difficult task of managing these highly regulated processes, company executives know that there will be a cost associated with the administration of these benefits and don't question too deeply when confronted with the bill. It's just a part of doing business.
On the other hand, the mechanics and cost of administering equity compensation plans for non-public companies remains shrouded in mystery and when that veil is pierced, business owners and executives are often caught off guard.
Humble BeginningsHistorically, equity compensation administration for early-stage non-public companies was a relatively simple affair, often done on a spreadsheet by paralegals assisting corporate counsel. Most of the regulations to be followed were mechanical and easily monitored by the board and the CEO—grant only the number of shares authorized in the reserve pool, ISO grants only to employees, ISOs must be exercised within three months of employee termination, and other similar rules.
Shortly after the turn of the century two events converged that would make spreadsheets not only unacceptable, but potentially dangerous—the backdating scandal of 2006 and the mandatory application of Accounting for Stock Compensation Topic 718 (formerly FAS123(R)) to equity compensation in non-public companies beginning in fiscal years starting after December 15, 2005.
What were once simple awards now required data security, audit trails, and complicated accounting calculations. Even if only the essential requirements are met, being able to prove that awards were made on a certain date when the stock price was a specific amount requires tracking the issue date and the processing date (thus the need for data security and an audit trail). Calculating the fair value of an equity compensation award requires the use of an option pricing model based on six factors, several of which require analysis of historic grant and forfeiture patterns and, thus, tracking of employee termination dates and forfeiture, expiration and exercise dates, as well as the time elapsed between the grant date and the forfeiture, expiration or exercise date (thus the need for an auditable solution that calculates the expense based on all of these factors, appropriately weighted to the company's circumstances). Add to these basics the requirement of equity accounting for some awards (e.g. ISOs) and liability accounting for other awards (e.g. non-employee NSOs), and auditors requiring straight-line expensing for some awards and tranche-based variable expensing for others, plus compliance with valuation issues presented by Internal Revenue Code Section 409A deferred compensation rules, and the myriad opportunities for losing control of this complicated activity become evident.
New Rules, New TechnologyThe enactment of these regulations has produced a corresponding increase in the technology available for complying with them. Legacy software vendors created expense calculation programs to add to or cross-sell with existing products. New vendors wrote comprehensive expensing programs into administration software that also cross-checks against other regulatory variables. While these technologies are more expensive than using an Excel spreadsheet, the advent of cloud computing opened the door for them to be delivered over the Internet, thus eliminating the need for expensive software updates each time the regulations change. Depending upon the number of plan participants, and the specific functionality that meets your company's needs, technology fees can range from a few thousand dollars per year into the tens of thousands of dollars per year.
Then, of course, you'll need someone qualified to do the actual administration, monitor the database, and take ownership of the expensing process. It is highly important to select a qualified individual as your administrator; someone who understands all of the underlying issues and the interplay between tax, accounting, finance, securities laws, human resources, and plan design and administration issues. A direct hire of such a professional can be expensive and may not be economically feasible for early-stage companies. Fortunately, there are several outsourcing alternatives, with a wide range of fees; just be sure that whoever is in charge of the administration has the Certified Equity Professional designation awarded by the CEP Institute. The CEP is the only professional certification for the equity compensation industry and ensures that your administrator has a clear understanding of all equity compensation issues and a network of expert-level resources in the industry.
In conclusion, administration of equity compensation awards demands the same high level of professionalism and exactitude as administration of any other employee benefit program, and the costs of administration need to be included when factoring the overall cost of the benefit plan. The expense of failing to put priority on proper administration can be calculated in elevated audit fees and, worst case, penalties and interest assessed by the Internal Revenue Service or disqualification of your entire equity compensation plan.
Achaessa James, CEP is the NCEO's resident expert on this topic and can provide more in-depth discussions of these issues. Contact her at firstname.lastname@example.org.