IPOs and the “Cheap Stock” Issue

Despite the recent market volatility, the 2015 equity market continues to support initial public offerings (“IPOs”). Through September 30, 2015, 161 IPOs were completed, which is down compared to 228 IPOs in 2014; however, multiple industry journals are indicating the fourth quarter of 2015 will be highly active.

When a company embarks on an IPO, one of the significant challenges in the registration process with the U.S. Securities and Exchange Commission (“SEC”) is mitigating, or preferably, avoiding, the SEC staff’s concerns regarding “cheap stock.” As companies prepare for an IPO, it is important to ensure that contemporaneous valuations are being prepared with appropriate frequency in order to support the accounting for equity-based transactions, including the granting of stock-based awards.

The valuation of equity awards issued to employees for compensation at a value that is less than fair value is considered cheap stock. In many instances the fair value of equity awards granted in the twelve to eighteen months prior to an IPO is lower than the price at which the same securities are being sold in the IPO. The SEC continues to focus on this as a key accounting issue during an IPO to ensure companies are accurately reflecting compensation charges in their earnings.

During its review of an offering document, the SEC will focus on stock-based awards granted during the most recently completed fiscal year along with any subsequent interim periods. They will compare the midpoint of the estimated IPO price range, as disclosed in the company’s registration statement, to the weighted-average exercise price of equity awards granted during the periods under review. The SEC will issue comments asking the company to explain the change in value between the dates of recently granted equity awards and the date on which the midpoint of the estimated IPO price range is disclosed.

Generally, the estimated IPO price range is not disclosed in the initial filing of the company’s registration statement, which can make the timing of these comments problematic. Companies will typically disclose the IPO price range in a subsequent amendment to the registration statement, after all other comments have been cleared, filed just prior to the start of the investor road show.

Companies can mitigate risk associated with a cheap– stock finding in a number of ways. In the twelve to eighteen months leading up to an IPO, companies should engage valuation professionals to provide contemporaneous equity valuations in connection with significant transactions or events that impact the entity’s capitalization or enterprise value. These significant transactions or events might include financing transactions, significant product or business developments or breakthroughs, or large grants of stock-based awards to employees, directors or consultants. Companies should consider the following when engaging third-party valuation specialists:

Valuation Standard: Companies should engage certified valuation professionals that adhere to the
AICPA’s Accounting and Valuation Guide “Valuation of Privately-Held-Company Equity Securities Issued as Compensation.” Companies should perform an appropriate level of due diligence in order to gain comfort over their third-party advisors.

Contemporaneous Valuations: Companies should perform common stock valuations at frequent intervals or on a basis contemporaneous with significant events or equity transactions. As it relates to the granting of stock-based awards, valuations should be prepared as of the date of grant (or in close proximity to such grant date) in order to validate the exercise price of the awards. If not planned to be completed in advance of stock-based award grants, valuations should be performed retrospectively in order to support the award value.

Assumption Validation: Companies are expected to validate the appropriateness of the assumptions and estimates underlying the valuations, as well as the reasonableness of the assumptions and estimates from valuation to valuation. The assumptions need to be reasonable, supportable and consistent with the company’s financial position and forecast assumptions as of the valuation date. The assumptions and estimates underlying the valuations must be supportable with respect to the company’s financial performance and other qualitative factors and developments within the business, industry and financial markets.

Disclosure: The registration statement should include clear disclosure as to how the fair value of the company’s stock-based awards and the underlying stock were established. The disclosure should include a description of the valuation method(s) and key assumptions used in preparing the valuation and related calculation of compensation expense, as well as a discussion of the significant factors that contribute to the changes in the fair value of the company’s common stock between valuation dates.

In some cases, market conditions and/or other circumstances can result in a company beginning an IPO sooner than originally planned. This can leave the company with insufficient support for its accounting for stock-based awards over the most recent twelve to eighteen months. In this situation, companies may need to consider engaging third-party valuation specialists to perform retrospective valuations as of key dates during the period subject to review by the SEC.

Regardless of the timing or circumstances, it is important to assess the risk of a cheap-stock issue early in the IPO process. Companies should prepare a preliminary analysis of their ‘valuation story’ over the preceding twelve to eighteen months. This analysis should include an analysis of the stock prices used in accounting for stock-based awards. This analysis should consider all factors of the ‘valuation story’ including:

  • third-party valuations performed (including valuation methods, key assumptions, estimates used and the timing (contemporaneous or retrospective))
  • any completed debt or equity financing transactions, or other changes in the company’s capital structure, including changes in the relative rights and preferences of the outstanding classes of stock
  • changes or developments in the business during the review period, and any other relevant factors that would impact the company’s enterprise value
  • other significant events

In the event this analysis identifies a non-standard pattern that would call into question the appropriateness of the company’s assessment of the fair value of stock-based awards granted during the period, companies should take care to validate the appropriateness of the valuations and assumptions with its advisors and auditors. Companies may need to consider obtaining additional valuations and where indicated, adjusting the amount of compensation expense recorded during the periods subject to review by the SEC.

Companies should also consider engaging in a dialogue with the SEC early in the IPO process. Given the SEC’s practice of assessing and issuing cheap stock comments late in the registration process (generally, just as the company is beginning the investor road show), a practice has emerged where companies will send a confidential supplemental letter to the SEC prior to receiving any cheap stock comments from the SEC. In these letters, companies will share the expected price range with the SEC ahead of public disclosure as well as provide the SEC a qualitative and quantitative assessment of the changes in the fair value of the company’s stock leading up to the IPO. This will allow the SEC to perform their review earlier and allow the company to respond to any comments before the start of the investor road show.

Just like the intangible assets that distinguish the value of each enterprise, the fact pattern to establish a common stock valuation for each company varies. Companies should mitigate the risk of delay in an IPO by identifying cheap stock concerns and addressing those concerns in advance of filing a registration statement.

CFGI has significant experience assisting clients with securities registrations, including IPOs, and valuations of companies’ equity. This experience has deepened our knowledge and expertise with respect to the securities registration process and allows our clients to mitigate the risk of a prolonged exchange with the SEC at the time a company is pursuing an equity offering.

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