December 31 is fast approaching. Can audits be far behind? Every year as we help our clients maneuver through the audit process, it seems that one of the areas that can cause significant difficulties is equity. It’s not so much the basics, like recording the issuance of 5 million shares of Series C preferred at $3 a share, or the exercise of a stock option, but the “little” issues that don’t pop up until the financial statements are actually being prepared and the footnote disclosures drafted. Things like stock option modifications (that’s a modification?!), accounting for nonemployee options (what do we remeasure and when?), common stock valuations (we did a 409A valuation in October; why do we need another?) and warrants (what do you mean, the warrants are liabilities?). Let’s take a closer look at these issues.
Stock option modifications
Everyone recognizes that a stock option repricing is an option modification. But a lot of other transactions are also considered modifications—and as such have accounting consequences—including extending the post-termination exercise period; exchanging stock options for other types of awards, such as restricted stock units; and changing the option holder’s status from consultant to employee (or vice versa). Altering the vesting terms of an option or other award can also trigger accounting ramifications. In some cases, only the timing of the expense may be affected. In other cases, including accelerating vesting at termination or changing performance criteria, the value of the option must be remeasured, and additional expense may result.
Accounting for nonemployee options
In general, the measurement date for a nonemployee option is the vest date, not the grant date. So technically, you should remeasure nonemployee options on each vesting date, which can be a rather daunting task if your options vest monthly. Fortunately, most auditors are okay with quarterly remeasurement. However, if you are calculating all remeasurements at year’s end, you may discover unexpected issues related to common stock valuations (see below). Also keep in mind that not all software is created equal when it comes to managing nonemployee stock options. Testing your system by manually recalculating expense for a sample of nonemployee options is always a good practice.
Another thing to remember: once each option tranche has vested, the vested shares are no longer subject to remeasurement. We occasionally see situations in which a company has continued to remeasure all shares until the option is fully vested. This practice misstates expense, frequently overstating it.
Common stock valuations
How often do you really need to have a common stock valuation, also referred to as a 409A valuation, performed? The answer is one of those very definite “it depends.” If your company is relatively stable, an annual valuation may be sufficient for both tax and accounting purposes. But if your company is dynamic and reaching significant milestones, you will likely need 409A valuations more frequently. Let’s say you closed your Series C round in September and had a 409A valuation performed in conjunction with that event. In December, your company achieved a significant milestone, like introducing a new product or receiving a favorable result on its Phase III trial. The December milestone increased your company’s value and likely requires a new 409A valuation. Performing the valuation contemporaneously and proactively is best. Dealing with it when your auditors request it usually adds significant time to the audit and could add to the cost of the valuation if the valuation firm has to expedite its work to meet your timelines.
Warrants
Warrants could easily be the subject of an entire article, but here are a few things to be aware of for now. Companies frequently issue warrants for preferred or common stock in connection with debt agreements (bridge loans, term loans, lease lines, and so on) or equity offerings. In all cases, the proceeds that the company receives must be allocated between the warrants and the base loan or equity offering. If the warrants are for preferred shares and there’s any possibility your company will redeem the underlying preferred shares for cash, the warrants are considered liability instruments and must be revalued at each balance sheet date with the change in value flowing through the statement of operations. In addition, if the base loan is convertible into equity, as is generally the case with bridge loans, the warrant will usually create a beneficial conversion feature because of the allocation of a portion of the proceeds to the warrant. Addressing these situations can be confusing and time consuming. Best practice is to discuss them with your accounting advisors before actually sealing the deal so that any accounting issues can be addressed up front.
Wrap up
Before you say good-bye to 2012, do two things. First, review your equity transactions, stock option records, board minutes and other relevant documents to determine whether any of the transactions or situations I’ve described occurred during the year. Then discuss your findings with your accounting advisors, equity service providers or both to ensure that the proper accounting treatment has been applied. You will certainly be better prepared for your audit, and you may save yourself from some significant headaches and maybe even some audit fees.
