Registrants who have issued stock, or granted stock options or warrants with exercise prices at a price significantly below the public offering price (sometimes referred to as “cheap stock”), shortly before going public, should ensure that they have a sufficient basis to support the valuation of the underlying stock when issued. The same is true for issuances of convertible preferred stock to vendors, service providers, or customers shortly before the IPO when the conversion price is below the IPO price and the registrant recognized the issuance at a fair value significantly below the underlying conversion value.
For example, a nonpublic company may grant a typical fixed, at-the-money stock option six months before its IPO. The offering price at the time of the IPO is $10 higher than the option’s exercise price on the grant date. If, in the six-month period preceding the IPO, there was no discrete event that increased the fair value of the underlying stock, there is a presumption that the option was a “cheap stock” grant. This means that, in effect, the company granted an in-the-money stock option. In this case, the company would have to rerun its option pricing model and record compensation cost to reflect the higher fair value of the deemed in-the-money option as opposed to the value of the option when assumed to be at-the-money.
Items affecting the likelihood of an assessment that the company has failed to properly recognize the compensation cost associated with cheap stock in the period prior to an IPO include:
- Whether there were any equity or convertible security transactions with third parties for cash within a reasonable period of time of the grant, and the size and nature of such transactions
- Appraisals by reputable valuation experts independent of the IPO that were prepared at or near the grant date
- Changes in the company's business that would indicate there has been a change in the value of the business, such as new contracts or sources of revenues, more profitable operation, etc.
- The length of time between the grant and the date of the IPO
- Adequate documentation from the date of the grant or earlier that supports the valuation used by the company at that time
- Transfer restrictions
A common misconception is that there is a preconceived range of acceptable discounts from the IPO price dependent upon the period of time that shares or options were issued prior to the IPO. Each situation needs to be evaluated based on its own particular facts and circumstances. No arbitrary range of discounts should be assumed to be "acceptable." Any value assigned to stock issued or options granted (regardless of the extent of discount from IPO price) needs to be supported by relevant market evidence, not simply a general relationship between the IPO price and the length of time before the IPO that it was granted.
Evidence should focus on a registrant's own specific facts and circumstances and not broad industry factors. Acceptable corroborating evidence often necessitates a credible, independent valuation, particularly in the absence of proximate similar stock transactions with unrelated parties for cash. Preferably, the independent valuation should be performed at the time of the stock grant or award.
The AICPA Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation,
provides financial statement preparers, valuation specialists, and auditors (internal and external) with best practice guidance for valuing privately-held equity securities, including stock-based compensation awards that are within the scope of ASC 718
The guide also specifies enterprise- and industry-specific attributes that should be factored into a determination of fair value (e.g., the fair value of stock-based compensation awards that a company grants to employees), and describes important steps that a company should take when obtaining or performing a valuation. Finally, the guide discusses disclosures companies should consider. See FSP 15
Companies should prepare their cheap stock analyses concurrent with the issuance of the related securities or options and should update them in connection with preparing the IPO registration statement.
A cheap stock analysis should generally include the following for each equity-related issuance within the latest fiscal year and interim period through the date of the IPO:
- The date the security was issued and to whom
- The deemed fair value of the security, with objective and reliable evidence of how the company determined the value of such security, including factors that resulted in each change in fair value during the periods
- A timeline of events leading up to the filing of the IPO, including discussion and quantification of the impact on fair value of any company-specific events that occurred between the date the equity-related awards were granted and the date the registration statement is filed
This analysis should specify the reasons for any difference between the fair value at the transaction date and the estimated IPO price range.