The Employee Ownership Update
August 14, 2008
Cost Accounting Standards Board Finalizes ESOP Rules for Government ContractorsOn May 1, the U.S. Cost Accounting Standards Board issued final rules for reimbursable costs for government contractors that have ESOPs. Since the 1980s, there has been considerable uncertainty about how the costs of funding an ESOP would be treated. Under the final rules, the term "ESOP" includes any defined contribution plan designed to invest primarily in employer stock. Under these rules, reimbursements will be for the market value of the shares at the time a contribution is made. In a leveraged ESOP, this means the cost basis of the shares when purchased, not the accounting value under the American Institute of Certified Public Accountants' Statement of Position (SOP) 93-6, which requires a compensation charge based on the value of the shares released at the time they are released. Under the new rules, the cost will be assignable to a cost accounting period only to the extent an allocation is made to participant accounts by the tax return filing date, including any permissible extensions. For leveraged ESOPs, the allowability of the costs will follow Federal Acquisition Regulation Part 31, which allows companies to charge the costs of principal and interest on an ESOP loan provided the stock is acquired at fair market value. The regulation does not distinguish in this regard between S and C corporations. Companies operating under an existing approved reimbursement procedure can retain that method or renegotiate under the new rules.
The rules also state that dividends used to repay a loan are allowed as a cost. However, there is some uncertainty about this as a Boston office of the Cost Accounting Standards Board recently denied reimbursement for dividends.
Study Finds Broad-Based Options in Venture-Backed Companies Both Common and EffectiveData on the extent and effectiveness of broad-based equity plans in closely held companies are scarce and based on samples too limited to be persuasive, but we recently came across one significant exception. In "Give Everyone a Prize? Employee Stock Options in Private Venture-Backed Firms" (2005, unpublished), John R.M. Hand of the Kenan-Flagler Business School looked at data from 2004 and 2005 provided by VentureOne, a provider of data on venture-backed firms. The sample consisted of 1,032 venture-backed companies responding to the survey for which adequate data were available. The study found the mean percentage of employees getting options was 89%, and 74% of the companies granted options to everyone. In other words, contrary to the conventional wisdom that broad-based equity awards have been disappearing in venture-backed companies, they are in fact almost universal.
Hand's study looks at whether granting options deeply into the organization is a good strategy for venture investors. He correlates the fraction of the firm's employees receiving shares and finds that granting options to more employees results in better performance than granting them more narrowly. The specific measures are too complex to describe here, but they essentially create a hypothetical optimal depth of options granted. Using that optimal depth, Hand concludes that firms that err of on the side of too many people getting options do better than those that err on the side of too few.
The argument here is that granting options too far down poses minimal risk because lower-level employees usually get smaller grants. In contrast, not granting far enough downthe ladder can create a substantial risk that potentially critical people will not be retained or motivated. So it is better to err on the side of caution.