Your good client Frank Bunker Gilbreth is planning the IPO of his consulting company, Therblig, Inc. Frank tells you that Therblig has granted equity awards to dozens of employees during the past 12 months and he wants to know if there will be any issues with Therblig’s planned IPO. While you know enough to know that equity awards are one thing that should not be cheaper by the dozen, you are a bit hazy on the “cheap stock” problem.

Here is what you need to know to avoid the cheap stock trap.

The Cheap Stock Basics

Any equity grants to employees during the 12-month window preceding the filing of an initial public offering registration statement are susceptible to being deemed cheap stock — underpriced pre-IPO equity awards that require an additional earnings charge.

Under accounting and tax rules that apply to equity awards, the value of an equity award on the grant date is considered compensation expense on the company’s income statement for purposes of U.S. GAAP and may constitute taxable income to the employee for U.S. income tax purposes.

When a company makes pre-IPO equity awards at valuations substantially lower than the IPO price, questions arise whether the company has issued cheap stock to its employees. The SEC Staff will scrutinize pre-IPO equity awards to ensure that issuers have correctly accounted for the awards and have included disclosure in the IPO registration statement regarding the process and substance behind the issuer’s valuations of its equity awards.

An issuer that has not correctly recorded compensation expense could face a pre-IPO restatement of its financial statements to correct errors in compensation expense associated with prior equity awards.

How to Avoid the Cheap Stock Trap

The best way to avoid trouble with cheap stock issues is to avoid equity awards entirely during the 12-month period before the filing of your IPO. But, in the real world, complete abstinence may not be realistic for many pre-IPO companies, so the next-best solution is to use protection:

  • Obtain contemporaneous independent valuations that follow the valuation guidance in the AICPA’s VPES Practice Aid, with respect to all equity awards made during at least the 12-month period before an IPO filing.
  • Preemptively address the SEC’s focus on cheap stock issues by including disclosure in the IPO registration statement regarding the process and substance behind the company’s valuations of its equity awards, including the factors and events that resulted in changes in the equity value and ultimately the IPO price.
  • Be ready to provide the SEC Staff with a detailed analysis regarding the process and substance behind your valuation determinations. If you obtained contemporaneous independent valuations on each of the targeted grant dates, you will be well armed to discuss the key drivers in these earlier valuation determinations.

The Cheap Stock Survival Guide contained in our Client Alert (available here) discusses in detail the specific information you will need to provide in your IPO registration statement and in the SEC review process.