Reopening Stock Options Battle –

Despite its defeat in 1995 in trying to force companies to value and expense all stock options, the Financial Accounting Standards Board (FASB) has once again reignited the issue, setting a course that threatens to damage our entrepreneurial culture and seriously erode our economic foundation.

The FASB learned a lot from the drubbing it took from the high technology and venture capital communities years ago, so instead of targeting all stock options, the board is now going after certain options for forced valuation and expensing but leaving employee options alone.

This new approach is merely the FASB’s back-door attempt to obtain what it has always wanted: forced valuation and expense of ALL stock options. On March 31, the organization, a private organization that sets accounting standards for companies registered with the Securities and Exchange Commission or that use audited financial statements, issued an Exposure Draft for public comment. The draft stated that only employees as defined under “common law” would be permitted to take advantage of the special accounting treatment for stock options; that is, a company is not required to expense stock options but must make specific disclosures regarding their value at grant date.

Employees, as tentatively defined by the FASB in its proposal, would exclude all options given to outside directors and independent contractors. Such non-employee options would have to be valued at vest date and expensed. The agency is not only forcing companies to expense stock options, but also to do so at vest date rather than the day the options were granted. In effect, the FASB has re-opened the entire stock options debate, which covered ALL stock options and argued for the vest versus grant date for valuation purposes.

There are many policy and accounting reasons explaining why the organization is simply wrong when it attempts to define who is an employee for stock option purposes. First, options are incentives for all recipients. They ally the interests of the stock option holder with the interests of the company, which creates a synergy that no other incentive can duplicate. Whether the recipient of a stock option is a common law employee or not, the result is the same: He will work his hardest so he and the company can succeed.

Any venture capitalist or new company will confirm the increasing difficulty in locating and securing talented board directors to steer a company in the right direction. And stock options are a major reason why many individuals decide to assume the responsibility of being a board director.

Many high technology companies hire independent consultants who sit side by side with company employees and perform identical functions. However, under the FASB’s tentative rule, if, as is often the case, both company and consultant receive options, the accounting for their options will be vastly different. This clearly is a case where accounting practices override substance.

The agency stated in 1994 its belief that stock compensation should be consistent between employee and non-employee service providers. For example, independent contractors should receive compensation based on the fair value of the services provided or, if more clearly evident, the fair value of the equity instrument exchanged for those services. Why has the FASB changed its position?

Finally, the FASB ignores an accounting definition of an employee used in Generally Accepted Accounting Principles (GAAP), which would be much more applicable than the common law definition of an employee, but of course, it would fail to justify what the organization aims to do. Under Generally Accepted Accounting Principles, an employee is defined in specific compensation arrangements as a person who has rendered or is presently rendering service.

If the board wins this time there is no reason to think that several years from now the board will announce that because companies now value options – however questionable this value is – for outside directors and independent contractors it can value options at vest date and expense them for employees as well.

In short, the FASB will have won the very battle it resoundingly lost several years ago.

To prevent this from happening, the NVCA believes the same potent force unleashed in 1994 must be brought to bear in 1999. First, all venture capital firms and emerging growth companies must submit comments by June 30 in opposition to the board’s tentative decision. Second, public officials must be told that the issue for which they fought so hard in the mid-1990s – disclosure of all options, not forced valuation and expense – is now in danger of being seriously eroded by the organization.

Do not let the FASB win piecemeal what it was not able to win in whole in 1995. Fight to keep consistent stock option accounting.