Two recent developments demonstrate that the SEC is more closely monitoring companies’ pre-IPO stock awards. Those of us old enough to remember when Ronald Reagan and Margaret Thatcher ruled the world, recall routinely facing the so-called “cheap-stock issue” when preparing companies for IPO. It might have been Code Section 409A that reduced the frequency of cheap stock issues (or maybe it was the deep slow-down in the IPO market during the recent non-recovery).

Last week/month, the SEC's Division of Corporation Finance updated Section 9520 (“Share-based Compensation in IPOs”) of its Financial Reporting Manual (careful before you print this: it is 377 pages). These updated rules (set forth fully below) emphasize the valuation process and difference between the IPO price and the fair market value used for the last pre-IPO awards.

9520 Share-based Compensation in IPOs

(Last updated: 2/6/2014)

9520.1 Estimates used to determine share-based compensation are often considered critical by companies going public. In particular, estimating the fair value of the underlying shares can be highly complex and subjective because the shares are not publicly traded. The staff will consider if a company performing these estimates is providing the following critical accounting estimate disclosures in its IPO prospectus:

  1. The methods that management used to determine the fair value of the company’s shares and the nature of the material assumptions involved. For example, companies using the income approach should disclose that this method involves estimating future cash flows and discounting those cash flows at an appropriate rate.
  2. The extent to which the estimates are considered highly complex and subjective.
  3. The estimates will not be necessary to determine the fair value of new awards once the underlying shares begin trading.

Companies may cross-reference to the extent that this, or other material information relevant to share-based compensation, is provided elsewhere in the prospectus.

9520.2 The staff may issue comments asking companies to explain the reasons for valuations that appear unusual (e.g., unusually steep increases in the fair value of the underlying shares leading up to the IPO). These comments are intended to elicit analyses that the staff can review to assist it in confirming the appropriate accounting for the share-based compensation, not for the purpose of requesting changes to disclosure in the MD&A or elsewhere in the prospectus.

9520.3 The staff will also consider other MD&A requirements related to share-based compensation, including known trends or uncertainties including, but not limited to, the expected impact on operating results and taxes.

Confirming the SEC staff’s focus on share-based compensation in IPOs, PricewaterhouseCoopers LLP released a report in December 2013, “2013 SEC comment letter trends: Employee stock compensation,” which reveals some interesting findings (this report is short, so you can print and read it). PWC found that the majority of the SEC staff’s comments related to employee stock compensation fell into three related categories: disclosure, valuation, and accounting recognition. Of the 118 stock compensation comments received for 2013, approximately 41% related to valuation and 50% related to disclosure (with many of these relating to valuation disclosure issues). Of those, 29% of the disclosure comments related to IPOs.

Valuation: One-third of the SEC staff’s valuation comments related to IPOs.

Similar to the disclosure comments related to IPOs, many of the valuation comments related to IPOs focused on explaining the differences between the most recent valuation of the stock and the IPO price. The following are a sample of the valuation comments related to IPOs we analyzed for 2013:

  1. Please tell us whether you have had any preliminary pricing discussions with your underwriters. If so, please tell us about the substance of those discussions and tell us whether those discussions were considered in determining the estimated fair value of your common stock during 20xx, specifically for the December 20xx grant.
  2. As a reminder, when your estimated IPO price is known and included in your registration statement, please reconcile and explain the difference between the fair value of the underlying stock as of the most recent valuation date and the midpoint of your IPO offering range.

Many of the SEC comment letters requested additional information or confirmation regarding comparable companies, volatility calculations, arm’s length transactions, or changes in value between grant dates (cheap stock).

Disclosure: Many of the SEC staff’s comments on disclosure seemed to relate to valuation in general, and significant differences between recent valuations and the IPO price in particular:

Many of the IPO-related disclosure comments focused on explaining the differences between the most recent fair market valuation of the stock and the IPO price. This has long been an area of focus by the SEC staff in IPOs, and is often referred to as “cheap stock.”

The following are a sample of the disclosure comments related to IPOs for 2013:

  1. Disclose why the IPO price increased in comparison to the May 20xx valuations. Describe the significant reasons and assumptions that account for the increase.
  2. Please include additional disclosures to explain the increase in fair value from the March 31, 20xx valuation of $x.xx to the estimated IPO price of $xx.xx.
  3. Once pricing information is available, please revise to provide a specific discussion of each significant factor contributing to any significant difference between the estimated fair value of your stock and the estimated IPO price (or pricing range) for the xx months prior to the contemplated IPO. Please also disclose the aggregate intrinsic value of all outstanding options based on the midpoint of the estimated IPO price range.

Accounting recognition: A minority of the stock compensation comments received for 2013, only 9%, related to accounting recognition. Two interesting areas on SEC inquiry in this area addressed companies’ (a) decisions not to recognize expense for share-based awards made before the IPO, and (b) consideration of a repurchase feature as a forfeiture provision, thus reducing the grant date fair value.

Companies considering an IPO in the future (and their counsel) should read this report.