Diligent's oversight could be costly
OPINION: Few phrases are more alarming for investors than "we may need to restate our accounts".
It has that awful uncertainty - the problem could be an insignificant administrative touch-up, or a complete rewrite of everything you thought you knew about the business, or anything in between.
The fateful words were uttered on Tuesday by Diligent Board Member Services, a New Zealand-listed, United States-based software company.
It said: "Diligent . . . is likely to receive a report today from a major accounting firm which may result in the Diligent board . . . restating its accounts for the 2012 year and some prior years."
There was little other information save that the problem involved the cancellation of stock options issued to some executives.
No wonder the company asked for a trading halt on its shares - you could scarcely have a properly informed market after a vague announcement like that.
Regardless of the share price reaction, however, after digging into the background. I think some boardroom bloodletting could be on the cards.
Diligent is one of those much-hyped tech stocks whose shares have soared well beyond the earthly domain of conventional valuation.
Before the trading halt was imposed, Diligent shares changed hands at $5.35, valuing the company at a heady $448 million.
That's a big number for a company whose last half-year accounts showed revenue of US$18.3m (NZ21.9m) and net profit of US$3.4m.
But Diligent is a high-growth business and its shareholders are confident its ever-increasing sales will accumulate into seriously big profits down the track.
In a presentation to investors last month, the company said its product - an online service helping company boards handle their documents - had 52,000 users at 1808 public and private companies. That's a big increase on the previous year's 27,500 users at 1025 companies.
And because it sells its software as an ongoing service, rather than a one-off item, the rising customer base represents growing revenue.
The company gave an update last month highlighting various fourth-quarter figures including revenue, new sales and cumulative sales, although profit figures have not yet been released.
Indeed, Diligent zealously keeps the market informed of its quarterly sales progress, constantly hammering home the message that its product is marching towards global dominance.
The story has attracted some very smart professional investors, who have been rewarded with share price growth of more than 600 per cent in the last two years.
After Diligent's horror start in 2007, when its shares were savaged over poor disclosure, it's an impressive recovery.
Unfortunately, niggles about Diligent's governance have never quite gone away and, in December, they resurfaced with an announcement it had appointed a special committee to review its grant of executive options, which "may not have been issued in strict compliance with the relevant stock option and incentive plans".
Last month the committee announced its ugly finding that way too many options had been issued, particularly to chief executive Alessandro Sodi. The excess awards were "inadvertent" and would be cancelled, it said.
The announcement didn't go into detail, possibly because the detail was the financial equivalent of a stool sample in a doctor's waiting room.
What it did say was that, in 2009, an option award to Sodi exceeded the maximum allowed by 1.6 million share options, and a 2011 award exceeded the cap by 2.5 million.
Trolling through previous disclosures, it is apparent that these options have become hugely valuable to the chief executive. The 2009 options have a strike price of US14.4 cents, while the 2011 options have a strike of US75c.
The strike price is how much it costs to buy a share when you exercise the option. It was set at the market price of shares when the award was made.
So, the 2011 options convert to a right to buy Diligent shares for about $1.10. With a current market price of $5.35, the deal would amount to a profit of more than $4 a share.
Multiply that by 2.5 million and the 2011 option award could be worth more than $10m.
Add the 2009 options, which would convert at about 20c to produce a gain of $8m, and it looks like the award would be highly significant for Diligent's chief executive.
The thing is, the awards were made under two formal stock option and incentive plans adopted by the board, one in 2007 and one in 2010.
Both were filed to the US Securities and Exchange Commission and both explicitly state "no person shall be eligible to be granted awards covering more than 500,000 shares of common stock in any calendar year".
I tried to contact the two New Zealander directors on Diligent's remuneration committee - Rick Bettle and Mark Russell - to ask how the option awards could exceed the plans by so much. Russell did not return my call and Bettle hung up on me.
Meanwhile Diligent has been left with two problems - one, the excess option awards count as an expense against income (in 2011, for example, the total option expense was $907,543), so cancelling them changes the accounts; and two, it must figure out how to compensate Sodi for the apparent loss of millions.
That's quite a mess. For a company calling itself Diligent and selling a board governance product, it's a downright dog's breakfast.
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