June 2018

Don’t get trapped by your stock plan.

The purposes and benefits of equity incentive plans for private emerging companies are well covered in the literature and on the web. Therefore, in this article I will highlight some of the problems that organizations encounter when trying to optimize equity incentive plans for their employees.

The typical equity incentive plan provides for the granting of stock options to purchase common stock to employees, board members and consultants.  Incentive Stock Options (“ISOs”) may be granted only to employees, and have some favorable tax treatment potential vs. non-qualified stock options, which are granted to board members and consultants (and some times to employees in certain circumstances).  Many plans also provide for restricted stock grants, which allow the grantee to purchase their share allocation upon the grant, but with the company’s right to buy back the shares that have not vested, typically consistent with the stock option vesting schedule.  The benefit of restricted stock is that the holding period for capital gain purposes may begin upon the grant date, rather than when option shares are actually purchased over a vesting period, if the holder so chooses in a filing called a Section 83(b) Election.

Even in a well-constructed equity plan, however, there is the potential for companies to take certain actions which could get the grantees, the organization, or both in a financial pickle.  In my experience the principal issues involve common stock valuation and the use of restricted stock.

Common Stock Valuation

Stock options must be granted at a minimum of fair market value (FMV).  Failure to do so will subject the grantee to an ordinary tax on the difference between the strike price and FMV, plus a 20% penalty. Since a private company’s stock is not readily tradeable on an established securities market, the IRS requires that the FMV of that stock be determined according to a methodology know as a 409A valuation, and that the valuation be documented in a written report.

It is theoretically acceptable for a 409A valuation to be performed internally, and this may be tempting in order to save the cost of an independent appraiser.  However, most tax advisors believe that independent trained and experienced valuation professionals are the only safe option.  Such valuations have become less costly over recent years, and some professionals are offering this service on a monthly subscription basis.  Options should be granted within 12 months of the valuation, and valuations should be performed more frequently if the company has achieved milestones that would increase its value.  A valuation should definitely be completed after any new equity financing.

Use of Restricted Stock

Because of the additional complexity of administering restricted stock, most companies have limited their use to senior executives, although I have seen cases where they were offered to all employees.  The biggest downside to restricted stock is that they are no longer “options”; that is, the full exercise price of the shares must be paid upfront, without knowing the ultimate realizable value of the shares.  To offset the negative cash flow aspect, some companies have either loaned the employee the full purchase price of the shares, or given the employee a bargain purchase price and loaned them the amount of the tax due for the difference between the strike price and FMV.  Neither of these alternatives is advisable.

First, in order for a loan given in connection with a stock grant to not be considered a taxable event, it must be “full recourse”; that is, the loan is due and payable on a known timetable and is due for the full amount of the loan, plus interest, regardless of the value of the stock.  So, if the loan becomes due when the stock value has decreased (and is often illiquid), then the employee is on the hook for the full balance.  The company may be willing to forgive the loan at this point, but the amount of the forgiveness then becomes an ordinary income taxable event.

Another workaround would be for the company to repurchase the shares from the employee in order to reduce the balance of the loan.  However, since the current FMV of the shares has likely reduced from the original grant price, the loan would not be fully offset, or any premium paid for the shares by the company would subject the employee to an ordinary gain.  Nevertheless, under these circumstances it probably makes sense to repurchase the shares at FMV to minimize the loan balance.

To summarize…

In order to avoid negative tax consequences, or nasty surprises later (which often come to light at a liquidity event or the winding up of the company), my informal advice would be to always grant options at an FMV based on a current, independent 409A valuation, be very careful about the use of restricted stock, and never provide loans to support a restricted stock grant.  Finally, always consult a qualified attorney before implementing an equity incentive plan or considering any of the actions discussed above.  The qualifications you should look for include technical and legal expertise, as well as the real-world experience to understand what could go wrong.


Photo credit: Men in Bramhall stocks 1900. Public Domain.

Make sure you understand what lies underneath the data you use to make big decisions.

You’ve heard it many times and in many different contexts: garbage in, garbage out. This universal truth can have serious consequences for CEOs of young companies when it comes to financial reporting. The devil is in the database that provides the data that affects the numbers you rely on to take all kinds of decisions – from sales forecasting to modeling to pricing.

Sound financial planning requires data science to ensure data definition, design and governance support data analysis and ultimately, reporting. A CFO must understand more than their ERP (Enterprise Resource Planning) system such as Quickbooks or NetSuite. They must understand numerous data sources, how they relate to each other and how to reconcile them, because at the end of the day, a spreadsheet as a reporting tool will only be effective with proper data definitions and a solid database design.

Good CFOs start with design

To do proper reporting for bookings, revenue and SaaS metrics, it is critical to first design the data sources. I can’t understate the fact that database design is a critical step of any serious financial planning and analysis (FP&A) that can provide executives the knowledge then need to make decisions about their startup. If the data is poorly structured, incomplete, or inaccurate, the tools for analysis (i.e. a spreadsheet, Looker, SaaSOptics, etc.) will be at best limited in their usefulness; at worst, it will provide wrong information that can lead to poor decisions.

The Devil is in the Data

For example, let’s focus on SaaS bookings – whose reporting  often seems to be controversial within the organization. To design an accurate spreadsheet to reflect sales, your CFO needs to determine, first, what is the definition and data source for a booking. For many startups, the data source is the Salesforce.com opportunity (either maintained there or replicated in an ERP system such as Zuora or SaaSOptics or held in a reporting database such as Redshift). The key here needs to be a total agreement on the database object or table that defines the booking. If you select the Salesforce opportunity, and export to Excel, then you can setup the opportunity to include the data element (field on record) for type with the possible values of (new, expansion, renewal or churn) and then use that data element or column in Excel to filter or build a report or a pivot table.

Another approach for designing the bookings database for SaaS could be to use a more granular level of detail, such as a contract or a subscription. Then, if the team needs to query the contract, they need to determine what is the definition and data source for a contract. In most Salesforce configurations, there is not a contract object – this is where sound design comes handy. Your CFO can create a contract object in a subscription management solution such as Zuora, SaaSOptics, and even on an Excel spreadsheet.

If you are creating reports based on the contracts or subscription, then you will need to ensure that your data table includes the following: a) common reference such as a customer ID, b) unique contracts or subscriptions id, c) subscription data such as start date, end date, item, amount, etc. With this data table, you can apply logic to determine if new, expansion or renewal. For example, if there is a subscription with a customer ID and new prior subscription (use start and end dates) with the same customer ID, then the subscription is new. If the start date is coterminous with the end data of a subscription with the same customer ID, then it is a renewal.

If there is a period with no revenue but revenue in the same period, then the amount of the previous period is churn. It should be obvious that a proper data structure will make the logic easier and you didn’t ask about re-activations (contract ends, there is a lag period, contract begins at a later period….is this churn, new, renewal or none of the above such as re-activation).

CFOs should offer Strategic and Tactical Skills

In a technology startup, CFOs are needed for many strategic efforts such as long-term planning, raising capital, assessing buy- and sell- side acquisitions, and hiring top talent. However, at times, many startup CFO’s must also lead data design and analysis. Often times, it is data and financial insight that helps to ensure success in the strategic efforts.

Photo courtesy of Christopher Michel.