As a Certified Public Accountant who regularly works with early-stage technology companies, I have come to accept that accounting usually is not a favorite topic among entrepreneurs. In fact, given all the other things an entrepreneur has to think about, conforming to generally accepted accounting principles and practices can end up fairly far down on the priority list.
I am a big believer that you don’t let accounting and tax rules tell you how to run your business. I also believe that a fuller understanding of the accounting considerations for equity and revenue recognition can help investors, entrepreneurs, and board members ask the right questions and know when to seek outside expertise to avoid unpleasant surprises, unanticipated adverse affects on the P&L, delays in due diligence, or renegotiated valuations.
I. Accounting for Equity
In today’s world, accounting for equity is more complex than ever before. Depending on the choices a company makes with equity awards, there are both financial reporting and tax issues. These issues are not always the same.
Entrepreneurs and their boards need to understand both the profit and loss impact and the tax ramifications of granting equity before any granting occurs. Whether the business is a Limited Liability Company (LLC), C-Corporation, or S-Corporation, the issues are generally the same.
Determining Fair Market Value is at the Core
When a company issues an equity security or option as compensation, both the Financial Accounting Standards Board (FAS 123R) and the Internal Revenue Service (IRC Sec. 409A) require the company to establish a fair market value for those securities as of the date the stock is issued or the options are granted.
The intent of FAS 123R is to make sure that the company’s financial statements accurately reflect current fair market value expenses of the grant. The IRS wants to make sure that any stock or options granted as compensation are not valued too cheaply.
The IRS and FASB requirements for setting the fair market value are similar, but not exactly the same. The consequences of being out of compliance include additional tax, interest, and penalties from the IRS’s standpoint and potential restatement of financial statements as the result of an audit, due diligence, or Initial Public Offering (IPO) filing to satisfy FASB requirements.
The following is a review of the accounting and to a lesser extent tax considerations of the various forms of equity that an early stage company is likely to use as compensation.
Prior to 2006 and FAS 123R, generally accepted accounting principles (GAAP) did not require privately held companies to report stock options as an expense as long they were granted at market value following the intrinsic value methodology. The intrinsic method was a theory that did not require the company to expense compensation as long as the options were issued at the fair market value. Since FASB 123R, all stock options must be recorded at their fair market value as expenses when they are granted, even if issued at the fair market value price of the stock.
To calculate the fair market value of the options (and therefore the expense), companies are required to use an option pricing model which satisfies minimum FAS 123R requirements (e.g., Black Scholes-Merton or binomial-lattice).
While a detailed discussion of these option models is well beyond the scope of this article, it is important to know that each requires the company to make assumptions about volatility, interest rates, and the dividend rate and life of the options.
The models also call for the company to establish a fair market value of the underlying stock, and this is where things can get very complicated.
It is one thing to be able to go to The Wall Street Journal or the Internet to get a price for a stock, or to establish the underlying value as a result of an investment round where the valuation of the company has been agreed. It is another thing entirely to come up with the underlying stock price when a company is just starting out and there is no valuation or current street price to base the stock price on.
A company cannot simply assign a price for the stock that seems reasonable. It is possible to establish a fair market value internally for tax purposes under IRC Sec. 409A as long the person setting the value is qualified and knowledgeable about valuation and has significant experience.
However, the calculations and considerations in a comprehensive report are so complex that many companies obtain an independent valuation report from a reputable outside appraiser to set an independent value to the common stock. These external assessments are usually a more effective way to meet the requirements that can make an accountant or auditor comfortable that the fair market value is credible.
An independent appraisal costs between $5,000 to $15,000. Very early stage companies that are pre-revenue may delay having an independent valuation to avoid these costs, but once a company has employees, transactions, revenue, and a board of directors, most accountants and CPAs—especially if they are auditing the company—will require an outside appraisal.
The fair market value of the underlying stock and the other assumptions (i.e., volatility, interest and dividend rates, life of the stock) are fed into the chosen algorithm (Black Scholes-Merton or binomial-lattice). From that calculation, the fair market value of the option is determined. This expense is then generally recognized over the vesting or earning period of the recipient of the option(s). As long as the grant of the option is issued at least at the fair market value, there will be no federal tax implication at the grant date to the company or the option recipients.
Options have a value that is set as of the date of the grant under FAS 123R. As those options vest, a corresponding expense must be charged against the profit of the company. The amount of this expense correlates to the value set at the date of the grant, no matter how the fair market value for the options may change. Even if the options are underwater, the company cannot subsequently adjust the expense downward.
Common and Preferred Stock Grants
Granting stock is an effective way to attract key employees early in the company’s life cycle. When a company grants actual stock (not options) to employees as a form of compensation or as payment for outside services, the fair market value of the stock must be recorded on the company’s books as an expense and reported to the IRS as taxable income to the person who receives the stock.
When granting shares of stock, a company’s first concern is satisfying the fair market value requirements of IRC Sec. 409A. The IRS will allow an independent appraisal, a nonlapse repurchase formula, or an illiquid startup valuation.
Management will want to seek the advice of someone with financial acumen who understands the IRS guidelines for the “reasonableness” of the valuation method used.
By following these valuation methodologies with sign-off from the board of directors, the company will at least be able to demonstrate that it followed the mechanics of IRC Section 409A if the IRS raises an issue with the resulting stock valuation.
If the company is seeking a fair market value that will stand the tests of both IRC 409A and FASB 123R, it is best to engage a Certified Public Accountant (CPA) well versed in equity accounting to verify that the methodology used for IRS purposes meets the minimum requirements of FAS 123R.
Stock appreciation rights are also subject to the IRC 409A rules. Keep in mind that board members or officers may find themselves on the hook for potential payroll taxes that are considered trustee taxes if issues with the IRS occur. In these situations, seek legal counsel.
With the economic downturn, many companies are finding their current option plan holders “under water” as the stock price is below the option price. Modifications to existing plans or changes in exercise prices most likely will have an accounting consequence to the company’s books so before making modifications a company should seek professional advice.
Restricted Stock Grants
Assuming that retention as well as attraction is also a goal of any stock compensation plan, granting restricted stock early in the company’s life cycle can be a superior strategy.
Under a restricted stock plan as compensation, management may put restrictions on the shares themselves or the grants of shares that permit the stock to vest over time. Examples of restrictions could be calendar events (a portion of the stock vests annually as long as the employee remains with the company) or milestone accomplishments (e.g., profitability, product releases, or sales goals).
For accounting purposes, if the restrictions create a “substantial risk of forfeiture to the recipient,” the company may not need to book the fair market value of the stock as expense, but rather may disclose it in the notes of their financial statements. When the event becomes probable, the company records the expense.
As the restrictions on the stock lapse and the stock vests, the employee pays federal tax on the vested stock at ordinary income rates based on the fair market value of the stock on the day it vests and the company recognizes the expense.
However, under a special IRS provision (IRC, SEC 83B), an employee can elect to pay the tax on restricted stock immediately by sending a letter to the IRS within thirty days of the grant stating their election to pay the tax today on the current fair market value of the stock. The employee will be taxed at ordinary income rates. As with all stock grants as compensation, the company reports the difference between the fair market value of the stock and any price the recipient pays as an expense.
This provision makes restricted stock a powerful tool for founders and early key employees. At the beginning of the company, the fair market value of the stock will typically be low. Under current IRS provisions, as long as the stock is held for a year and a day, any appreciation will be treated as long-term capital gain.
Warrants and Convertible Debt
A warrant is similar to an option except that it is usually issued with debt. A warrant provides the right (but not the obligation) to buy shares of stock at a certain price. Warrants, like options, must be valued at fair market value and are usually expensed over the life of the associated debt.
Convertible debt is a note that typically converts to equity at the option of the note-holder (lender) or when certain events, such as a subsequent investment round, occur. New accounting rules now require issuers to account separately for the liability and equity components of the convertible debt if the settlement can be settled at least partially or wholly in cash.
Market Capitalization Table: Keep it Simple, Accurate, and Up-To-Date
If a company ever expects to go through due diligence, whether as a candidate for private equity or in advance of an IPO, acquisition, or merger, the way they have valued their options and stock and the complexity and the currency of their market capitalization table become very important.
Keep the capital structure current, straightforward and clean. Limit the number of initial shareholders and the types of rights. We strongly advise our clients against giving different rights to different shareholders. Record each group of shareholders and option holders separately; list their names and document the terms and expectations of each category as the option or shares are granted.
The cap table is one of the most important items of due diligence. I have seen small companies with as many as 75 or 100 shareholders, with different terms and valuation, and a cap table that hasn’t been updated in months. Those conditions become a nightmare and derail the process, if not the deal, when it is time to raise angel or venture capital.
II. Revenue Recognition
In the early years of most companies, cash is the primary concern. It is likely and understandable that very aggressive deals and discounts will be offered to close sales and build a base of early adopters for the new company’s products and services.
Often these deals are structured as one-offs and are frequently a necessary part of moving the business forward. With sales people making creative proposals to customers to capture early contracts, companies must be aware that the way these proposals are structured can significantly impact the amount and timing of revenue that can be recognized.
Principles and Criteria for Revenue Recognition
The two basic principles of revenue recognition are:
- Revenue must be earned.
- Revenue must be realized.
Four criteria are generally required in order to meet the two principles of revenue recognition:
- Persuasive evidence of an arrangement exists (i.e., a contract)
- The arrangement is fixed and determinable (i.e., stated prices and rights of return are firm)
- Delivery or performance has occurred (no more services or obligations are due)
- Collectability is reasonable assured (the purchaser is deemed a good credit risk)
For most products—equipment, devices, hardware, or consumer goods—revenue recognition is reasonably straightforward as long as a company satisfies these criteria. With software, it is a different story.
In fact, the most difficult area of revenue recognition may well be in software, which generally falls under the American Institute of Certified Public Accountants rules entitled, SOP 97-2 “Software Revenue Recognition.” The guidance in this statute outlines a rule-based approach to complicated accounting issues. These provisions were instituted in 1997 as a result of companies trying to manipulate their earnings.
Since software companies and businesses that produce high technology products of which software is a significant component make up such a significant portion of angel investors’ portfolios, understanding some of the challenges of software revenue recognition will be useful.
Software Revenue Recognition
Companies follow several models when selling software. The software may be licensed as a stand-alone canned product, bundled with hardware, other software, or with post-contract support (PCS), or may be sold as a service (SaaS). Software may be plug-and-play or may require hours of contracted consulting to make it appropriately usable in the customer’s environment.
SOP 97-2 rules apply to companies selling software under any of these models and potentially to firms selling products of which software is one of multiple components. If embedded software is “more than incidental” to a system, hardware component, or other type of box, these accounting rules may apply.
Not every product that operates with software falls into this category, however. For example, there is a lot of software in a car or truck, but the automakers don’t have to use software recognition rules to account for their vehicles. On the other hand, a telecommunications company that sells a mobile device with cutting edge software may need to go under those rules.
As salespeople make different deals, a company can find that they have millions of dollars in deferred revenue. That is why we recommend that new companies establish standard contractual terms that anticipate revenue recognition issues.
We also recommend that a process be established that requires the accountant in charge of revenue or the company’s chief financial officer to review the terms of every deal before the proposals are submitted to the customer, so that the salesperson and the company both understand how the revenue will be booked and give the parameters and discounts of the deal. Tying the salesperson’s commission to revenue recognition is another tool to help the company manage these issues.
Stated Prices and Rights of Return
When software, post-contract support (PCS), or other services, such as help-line support or feature upgrades, are bundled together, the individual components of the bundled software contracts must have readily definable fair-market values that have vendor-specific objective evidence (VSOE) for the revenue generated by each component to be recognized.
Generally VSOE means a history of transactions with customers that demonstrates the fair market value of the various components and a pattern of customer acceptance. If the bundled components have been sold separately, the standalone price is the best evidence of VSOE.
Many products don’t have a separate sales history, especially in a young company. In these cases, VSOE can be set by “management having relevant authority.” In setting VSOE, some of the factors are type of customer, geography and distribution channels.
If a company cannot convince its auditors that it is conforming to the strict guidelines of VSOE, some portion of the revenue for bundled software transactions will most likely be deferred until VSOE is satisfactorily established.
A new company may need to have separate transactions paid for in the second year of the contract before it can establish a fair market value for non-software components of the original bundle.
Consider this example: An early stage company with a fiscal year that ends December 31 sells a piece of software for $100,000 in September and charges the customer an additional $10,000 for the first twelve months of software support. The company sends the customer an invoice for $110,000, and the customer promptly pays it.
Assuming the company has not previously established VSOE for its support at $10,000, the company will only be able to recognize $27,500 (3/12 of $110,000 fee for the software) by December 31 as the entire amount must be prorated over the twelve months specified for software support.
In year two, if the company has obtained VSOE and has sold another software package with the same pricing and terms, the $100,000 for the software license can be recognized in the month it is sold and accepted. However, the $10,000 for the software support will be recognized 1/12 per month for a year.
The amount of recognizable revenue cannot be based solely on list prices or the prices on a customer invoice. After a couple of years of selling the same components, a company that keeps good records will collect enough data to support the VSOE of each of the software components, but until that is the case, a good practice is to express all discounts as a consistent percentage of the license fee, the post contract support, and any other elements that are bundled together.
If a term license includes post-contract support, revenue recognition for the portion of the fee appropriately allocated to the support will be prorated over the term of the license.
The accounting treatment of bundled software sales must be handled properly and consistently, otherwise companies may find that they have corrupted their VSOE and this could result in deferred revenue and reduced profits.
Delivery and Acceptance
It used to be that when a client sold a piece of software, proof of delivery was easily determined by looking at the Federal Express or UPS paperwork. Today most software is delivered via automatic downloads over the Internet, subscription services or shared licenses activated by keys. Proof of the delivery is impossible unless the company retains electronic records or paperwork that verifies delivery.
We recommend that each of our clients establish a clearly written, company-wide revenue recognition policy that requires customer verification (paper or electronic) that the software was received, accepted, and it has been activated before revenue can be recognized.
It is also good practice to specify in the contract an end-date for any approval, installation or service period, otherwise the contract is so open-ended that recognizing the revenue will be deferred, potentially indefinitely. In one situation we saw recently, a 24/7 support arrangement had no expiration date on use. As a result, our client found it difficult to recognize any revenue at all on this element since contractually a customer could use it indefinitely. As a basis for revenue recognition in this situation, the company would need to prove that over time a percentage of their customers no longer used the 24/7 support, even though it was available indefinitely.
Sometimes the customer can’t use the software to their specifications until significant implementation efforts occur. Months and months of consulting may be required. Depending on the way the contract is written, revenue may be recognized on a percentage of completion basis or may have to be deferred on all elements until the customer indicates acceptance of the software.
For companies that follow a typical SaaS model, revenue recognition requires clear documentation of when the customer’s subscription begins. There are too many situations where the only way the accountants could determine that a user had subscribed to the service was when transactions actually started happening. Assuming there is documentation, it is easy to recognize revenue on a monthly basis for the most simple SaaS models.
If the company grants the client the ability to buy the software product today and commits to provide the next version for free, the company cannot book the revenue because they haven’t delivered the product that the customer is buying. This treatment can apply to products other than software, but most commonly comes up with software upgrades and new product releases.
Other Terms and Nuances Can Affect Revenue Recognition
There are specific accounting regulations for extended payment terms whether for a product or service, especially when a contract contains terms that are outside the company’s typical credit policy or different from other contracts in force.
Delivering a product and allowing the customer to pay over two or three years raises questions about collection and likely will delay the full revenue recognition of the contract. The auditor’s decision often comes down to whether or not the company can demonstrate a history of payment in general and from specific customers. Usually early stage companies cannot.
Granting customers specific rights of return or acceptance periods outside of the normal practice for the company can also delay revenue recognition. Issuing significant volume discounts to customers can also pollute recognition of revenue if not handled properly.
Entrepreneurs and their boards should not become so focused on accounting considerations that they let the accounting rules dictate how the business is run. By establishing a process that includes reasonable record keeping and review and by anticipating the basic rules and principles of equity accounting and revenue recognition, company management and boards of directors can avoid surprises. They will understand the implications of the operating decisions they need to make to cause the business to gain traction and grow and will hopefully avoid having to make major accounting adjustments when the auditors or due diligence teams come in.