Mr. Chairman and Members of the Committee, good afternoon.  I am Mark Heesen, president of the National Venture Capital Association (NVCA), which represents 460 venture capital firms in the United States.  As you know, venture capital is the investment of equity to support the creation and development of new, growth-oriented businesses.   Venture capital backed companies are critical to the U.S. economy in terms of creating jobs, generating revenue, and fostering innovation.  This segment of the economy, the entrepreneurial segment, is the true differentiator for the U.S. in terms of global competitiveness.  U.S. companies originally funded with venture capital now represent 11% of annual GDP and employ over 12 million Americans.    These organizations include AOL, Intel, Cisco, Home Depot, Amazon, Starbucks, Genentech, and Federal Express. 

I am here today on behalf of the Federal Express’ of tomorrow - our country’s venture backed start-up companies whose futures are being threatened by implications of the Financial Accounting Standards Board’s (FASB) Exposure Draft, Share-Based Payment, an Amendment of FASB Statements No. 123 and 95.  This proposal mandates the expensing of employee stock options.   The NVCA has a long history of working with FASB on the issue of stock options and our opposition to mandatory expensing is well known.   We continue to assert that the lack of a reliable valuation method to measure the “expense” of options will result in inaccurate financial statements, and will cost American companies billions of dollars in additional, unnecessary accounting and valuation fees.   The proposed rule will most seriously hamper the start-up business community, which may be forced to choose between using a tool that has made our entrepreneurial activity the envy of the world or wasting significant resources to produce reports that essentially misrepresent a company’s financial health.

Within the last year, the FASB has demonstrated an increasing disregard for the effects of its stock option accounting proposal on these private, emerging growth businesses.  Despite countless calls from small companies to make distinctions between themselves and large, publicly traded entities, the FASB has actually regressed significantly in this area.   The most recent exposure draft is a stark contrast to FASB’s stance in 1994 when it issued the current rule, FAS 123, in which exceptions were made for private companies.   Most assurances from FASB Chairman Robert Herz on addressing these issues have gone unmet with the one exception of the creation of a Small Business Advisory Group.  Unfortunately and perhaps conveniently, this group will not begin to meet until May of this year and will certainly not be functional in time to contribute to the current debate.  Other issues for privately held companies including those on valuation, the cost of compliance, and the risk to jobs at US start ups have been ignored.  I would like to share with you the problems associated with these areas.

Employee stock options are a critical factor in fueling entrepreneurial innovation and economic growth.  Entire industry sectors such as biotechnology, software, and microprocessors simply would not exist today without venture capital and employee stock options.  Almost without exception, young, growth oriented companies use options to attract the best and brightest talent at a time when cash is scarce.  These employees have the pioneering spirit that the US economy has been built upon. They take the risks to work for unproven organizations, knowing that through their stock option programs, they may be rewarded if the company becomes a success.  Employee stock options foster this American entrepreneurial spirit at all levels of organization, with an estimated 14 million workers holding these incentives. Should the FASB proposal go through as is, stock options will be too costly for most young companies to grant to all employees, seriously blunting an economic tool that has given U.S companies a competitive advantage over our foreign counterparts.  

One of the largest costs associated with the mandatory expensing of employee options is the cost of valuing these incentives.  Despite acknowledgement from both sides of the expensing debate that no accurate model for valuing employee stock options exists, the FASB has put forth three “acceptable models” for deriving an expense number.  The first, the Black Scholes model, has been widely discredited as being inaccurate for valuing employee stock options.  The second, the lattice or binomial method, uses inputs similar to Black Scholes but is even more complex, asking for more assumptions by the company.  Notably for start-ups, both Black Scholes and the lattice method require volatility as a critical input.  Yet, the underlying shares of a privately held company have never been liquid, so there is no precedent to derive a volatility number, thus creating a significant and costly accounting quagmire.  From a formulaic perspective, if one uses the “wrong” volatility, there will be a meaningful distortion of the value of the stock option.  FASB is familiar with this issue.  In promulgating the current stock options rules contained in Statement No. 123, FASB determined that measuring volatility for private companies was too difficult.  The FASB stated:

"An emerging entity whose stock is not yet publicly traded may offer stock options to its employees.  In concept, those options also should be measured at fair value at the grant date.  However, the Board recognizes that estimating expected volatility for the stock of a newly formed entity that is rarely traded, even privately, is not feasible.  The Board therefore decided to permit a nonpublic entity to omit expected volatility in determining a value for its options.  The result is that a nonpublic entity may use the minimum value method . . ..“  Basis for conclusions  174.  (The minimum value method allows the volatility input to be set at zero.)

Rather than continue to offer minimum value as an option for privately held companies, FASB’s new treatise neatly advises these start-ups to make a “policy choice”:  use the same fair value accounting as public companies (Black Scholes or lattice method) or use a third option,  “intrinsic value” reporting.   At first blush, the nod to intrinsic value may seem an acknowledgement by FASB of the particular valuation challenges faced by venture-backed companies.  However, offering intrinsic value – as defined by FASB in its exposure draft – is akin to offering no choice at all.

FASB defines “intrinsic value” as the amount by which the fair value of an equity share exceeds the exercise price of the option.  Historically, when granting options, both public and private companies set the fair value at the exercise price resulting in a “zero” intrinsic value for the options.  Of critical importance, however, is that the historical intrinsic value calculation took place only once, at a single snapshot in time – the time of the options grant.  Now, however, FASB has modified the intrinsic value calculation to require “that share options and similar instruments be remeasured at intrinsic value at each reporting period through the date of settlement.”

Valuation of a private, venture-backed company’s stock is a process, which at best is costly, complex, and inexact.  Absent new rounds of financing, venture capitalists rarely have information upon which to base changes of the set stock price because the stock is not tradable and the companies tend to be unique, with no like comparisons to benchmark. It is this continuous and repeated recalculation of intrinsic value that results in a Sisyphean challenge for venture-backed companies, requiring a constant analysis and calculation of the underlying stock value.   And, in the end, the final number will be an inaccurate, inconsistent and incomparable guess.

In addition to inaccurate financials, another serious concern is the monetary and human cost that will be required for young companies to undertake the valuation process.  These organizations cannot afford the outside expertise required to work through complex valuation models nor can they afford to spend the time to do this themselves.  Yet, FASB’s mandate will force small companies to address these accounting issues, distracting management, raising expenses and lowering the bottom line.  Implementing mandatory stock option expensing also imposes a financial reporting credibility cost that heavily impacts small companies.  Public company analysts have said that they will “look through” numbers impacted by stock option expensing to a companies’ underlying financials.  Yet, over 50% of the NASDAQ companies and virtually ALL private companies do not have analyst coverage.    Who is going to look through their numbers?  By placing this accounting burden on young companies, FASB is lengthening the reliance on expensive, high risk capital to the start-up sector.

In response to these issues, Chairman Herz has remarked that for non-SEC registrants, following GAAP is a matter of choice not a requirement.  However, venture-backed start-ups generally report their financials under GAAP because they do expect to one day move through an initial public offering or become acquired by a public company.   Further, it is a mistake to think that all the stakeholders in venture-backed companies are sufficiently sophisticated that they can make adjustments for this non-cash expense.  Private company financial statements are used by many constituencies, many of whom lack the data or sophistication to make adjustments, including customers, vendors, and employees. 

NVCA understands Congress’ reluctance to involve itself in the setting of accounting standards.  However, private companies are in a unique situation with virtually no recourse and FASB’s deadline looming.  While public companies can look to the SEC for additional guidance on many issues, private companies do not fall under SEC purview and have nowhere to turn for support.  We see an urgent need for checks and balances in our system at this time.

We believe The Stock Option Reform Act (S. 1890) seeks to preserve broad-based employee stock option plans and addresses the serious implications of expensing for emerging businesses.   By limiting mandatory expensing to the top five executives, the Act targets executive compensation while simultaneously preserving the ability of companies to deliver option plans to rank and file workers.  By exempting the expensing requirement for small businesses until three years after an initial public offering, the Act relieves the compliance burden from young companies seeking to go public and allows a company stock to settle down from the volatility of the IPO.    By setting the volatility at zero for valuation purposes as allowed under current FASB rules, the Act removes a key variable that creates a highly inaccurate expense figure.  Finally, by requiring the Secretaries of Commerce and Labor to complete a joint study on the economic impact of mandatory expensing, the Bill thwarts a “rush to regulate” effort by the FASB and prevents severe, unintended consequences for our economy and our international competitiveness.

Should the FASB move forward with its current stock option accounting mandate, the Board will be acting in direct conflict with its stated goals:

“The Board strives to determine that a proposed standard will fill a significant need and that the costs imposed to meet that standard, as compared with other alternatives, are justified in relation to the overall benefits from improvements in financial reporting….The Board has long acknowledged that the cost of any accounting requirement falls disproportionately on small entities because of their limited accounting resources and need to rely on outside professionals.”  (FAS 126, Exemption from Certain Required Disclosures about Financial Instruments for Certain Nonpublic Entities, basis for conclusions  9, 10, emphasis added.)

The inability to accurately derive volatility, and the difficulty in determining a common stock price for young private and newly public companies has not changed since the last FASB stock options pronouncement in 1994.  If FASB’s proposal is allowed to stand, what will change is the entrepreneurial energy that now accounts for over 10% of the U.S. economy.  This energy will be drained at a time when our global competitiveness is increasingly challenged by growing economies overseas.  International convergence of accounting standards such as mandatory expensing will touch the US and Europe, not China and India where accounting standards are more supportive of stock options.   Today, we applaud Congressional leaders for addressing the practical impact of FASB’s stock option expensing proposal.  We urge the passage of The Stock Option Reform Act as it seeks to protect our country’s entrepreneurial spirit while upholding the financial integrity and enhanced transparency sought by all.

Thank you for the opportunity to express NVCA’s views on these vital issues.