In reviewing registration statements for initial public offerings, the SEC's staff routinely analyzes whether the registrant should have recorded compensation expense with respect to stock options, restricted stock and other equity-based awards granted to employees, directors and consultants during the months leading up to the offering. This issue has received increasing attention from the SEC's staff in recent years. In general, the SEC requires the issuer to record compensation expense for any option granted to employees with an exercise price, or any stock sold with a purchase price, below the "fair market value" of the underlying stock on the grant date. This expense is typically amortized over the vesting period of the option, restricted stock or other equity-based award. If the issuer has had a significant number of "below-market" option or other stock-based grants often referred to as "cheap stock"the resulting compensation expense can adversely affect the planned IPO or, at a minimum, cause an unexpected drag on future earnings. However, early analysis and preparation by all members of the working group can minimize the disruption associated with an unforeseen "cheap stock" comment by the SEC's staff resulting in a restatement of the financial statements to record additional compensation expense. Every company planning to go public that has granted options or other stock-based awards during the prior 12 to 18 months at exercise or purchase prices below the low end of the anticipated public offering price range should prepare for a possible "cheap stock" comment. The issuer should be prepared to justify its determination of the common stock's "fair market value" as of each grant date, preferably by referring to objective evidence. The issuer can stock strengthen its position by referring to the stock prices that third-party investors paid at or around the time of the grants in question, to any independent appraisals that were obtained preferably at or around that timeand to significant milestones achieved or other changes in the business since the grant date. The principal rules governing the accounting for stock options and other stock-based awards are Accounting Principles Board Opinion No. Historically, companies accounted for all stock options in accordance with APB 25, which was adopted in APB 25 provides that the compensatory value of options should be calculated based on their "intrinsic value. Amidst intensifying scrutiny of executive compensation by institutional investors, the SEC and the public in the early s, the Financial Accounting Standards Board FASB issued an exposure draft of a new accounting standard for stock options in FASB focused on the shortcomings of APB 25's valuation approach, which takes into account only the option's built-in "spread" and not other factors such as the value deriving from the fact that options discount a right to purchase stock over an extended period. After considerable public discussion and controversy, FASB issued SFAS in SFAS encourages companies to account for employee stock options using valuation formulas that take into account all of the factors affecting an option's value, as described in more detail below. This approach usually results in higher valuations--and thus, larger compensation expense--than APB 25's "intrinsic value" approach. However, SFAS permits continued reliance on APB 25 with respect to employee stock options, so long as the financial footnotes disclose the pro forma effect of using SFAS 's methodology. The application of these basic rules continues to evolve, complicating companies' attempts to predict how the SEC will view their particular situations. The FASB has been working on an interpretive project to address what it sees as "diversity of practice" among companies' accounting for employee stock options under APB 25, which includes issues such as the proper definition of "employee" under APB Although the Software Publishers' Association and other industry groups have asserted that the FASB's project is designed to import concepts from SFAS into interpretations under APB 25, the FASB has insisted that it will base its conclusions "solely on the requirements of Opinion No. FASB's new interpretations are expected to apply prospectively but would cover events occurring after December 15, As an example, FASB has explained that options an employee stock option were to be repriced during the period from December 15, through the effective date, "variable-plan" accounting as described more fully below would be applied upon the issued date until the exercise date. The SEC will typically scrutinize options granted or other equity-based awards made within the 12 to 18 months preceding the filing of the registration statement. However, this time frame is not a universal one, and it is not unheard of for the SEC to request information about grants as much as two years old. The SEC's staff does not follow a formal pattern or principle--or plan to provide formal guidance--in this area. In general, the amount of compensation expense required to be reported will depend upon whether the issuer is relying on APB 25 or SFAS As explained above, APB 25 will usually result in lower compensation expense issued SFAS The amount will also depend on the date on stock the grant's principal terms are deemed to be sufficiently fixed for accounting purposes, and on whether the grant gives rise to tax-related adjustments. Companies may account for grants to their "employees" under either the "intrinsic value" standard of APB 25, or under the "fair value" standard of SFAS However, once a company elects to options on SFAS for employee grants, it may not revert to APB In addition, companies choosing to continue to rely on APB 25 must still disclose the pro forma effect of relying on SFAS in their financial footnotes. The FASB has tentatively concluded that APB 25 should only be available with respect to grants to "employees under common law. APB 25 measures the compensation associated with an employee stock option as the "spread" between the fair market value of the underlying stock on the date of grant, and the option's exercise price. These formulas take into account the option's exercise price and, more importantly, the expected term of the option, the market price and expected dividend rate of the underlying stock, the risk-free i. Treasury bill interest rate during the expected term, and the anticipated volatility of the stock price. Privately held companies need not take expected stock price volatility into account when valuing grants to employees under SFAS Grants discount persons other than employees, such as consultants and non-employee directors, are subject to somewhat different accounting treatment than grants to employees. In contrast to employee grants, which may be accounted for under either the "intrinsic value" standard of APB stock or the "fair value" standard of SFASgrants to non-employees must be accounted for under SFAS SFAS 's "fair value" standard often results in a higher deemed value than the "intrinsic issued standard of APB 25, which does not account for the "time value" of an option. Thus, grants designed to attract or retain outside directors or independent contractors can result in higher reported compensation expense than similarly-sized grants to employee s. The amount of compensation expense required to be reported will also depend on the tax treatment of the grant. The expense to be recorded will be reduced by the amount of the corporate tax savings if any expected to accompany the grant, such as the amount of the corporate tax deduction arising upon the grant of a non-qualified stock option NQSO. On the other hand, if the issuer makes stock "gross-up" payment to the grant recipient to offset some or all of his or her personal tax upon exercise of an NQSO, the issuer's compensation expense will be increased by the amount of the "gross-up" payment, after adjusting for any tax savings to the issuer. Determining the "Measurement Date. For most employee stock option grants, the "measurement date" is clearly the grant date, because the number of shares for which the option is exercisable and the exercise price are both fixed at that time. However, the measurement date can occur after the grant date. For example, an employee stock option to purchase a fixed number of shares at an exercise price equal to the stock stock in three years would have a measurement date on the third anniversary of grant. Renewing an option or extending its term also establishes a new measurement date at that time. In addition, since approximately the SEC has typically taken the position that option grants subject to later shareholder approval have a "measurement date" only when approval is obtained unless the approval is essentially a formality because management controls enough votes to ensure approvalwhich can result in significantly higher compensation expense if the company's valuation rises between grant and shareholder approval. SFAS also takes this approach, and FASB has concluded that this position should also apply for purposes of APB 25, pursuant to the interpretive project described above. Issuers should be aware, well in advance of any proposed IPO, of any features of their employee stock option grants or other equity-based awards that might render them "variable" grants for accounting purposes because their terms are not fixed at the grant date. Examples of "variable" grants include SARs that settle in stock, because the number of shares issuable is not fixed, and options with exercise prices that vary with the stock price stock depend upon the achievement of financial milestones. A "variable" option grant must be marked-to-market during each accounting period after the grant date, potentially causing an unexpected increase in compensation expense. Depending on the severity of the resulting accounting charges, issuers may find it advisable to settle out or otherwise eliminate any such variable grants, although the other accounting ramifications of this e. Occasionally, private and public companies will "reprice" existing stock issued either by reducing their exercise prices or by canceling the original grant and issuing new options with lower exercise prices. The recent stock market correction has increased public companies' stock in repricings, as a means of re-establishing the incentives once associated with their employees' deep-out-of-the-money options particularly for small-capitalization and "microcap" companies whose stock prices did not recently rebound to the same extent as larger capitalization companies. However, repricings are also receiving intensified scrutiny from the accounting profession and the SEC. The FASB has concluded that an option repricing creates a "variable" plan, so that any increases in the stock's issued from the repricing date to the exercise date would result in "mark-to-market" accounting charges for the life of options repriced option. In addition, the mere existence of a repricing may pique the interest of the SEC reviewer, leading to a more intensive analysis of the company's option grant practices. Under either APB 25 or SFASthe amount of compensation expense relating to an option or restricted stock grant must generally be charged to earnings over the period in which the services to which the option relates are performed. The related services are typically inferred from the award's vesting schedule. Thus, where options vest over five years, generally the deferred compensation expense will be amortized i. Thus, in many cases, substantial vesting periods cause the "cheap stock" compensation issue to be less severe than initially feared. The timing of the earnings charge is more complicated in the case of performance-based options and other "variable" grants, which frequently require periodic estimates of the expense followed by a final correction at the end of the applicable performance period. Some private companies planning to go public have intentionally structured the vesting of certain pre-IPO grants to result in an immediate expense at the time of the grant, on the theory that this will avoid a continuing drag on earnings during the quarter in which the IPO is priced and beyond. Of course, this approach may be impractical for employee stock options, in which ongoing vesting is important to maintain the appropriate incentives. Filing Issued a Price Range. Although this decision may be well-justified as a business matter, it can prevent the SEC from identifying potential "cheap stock" issues until relatively late in the offering process. At worst, this can result in the discovery of a significant cheap stock issue on the eve of the planned road show. Where the issuer disagrees with the SEC's view that there may be a cheap stock problem but has not yet had an opportunity to resolve the issue, this can raise difficult disclosure issues for the "red herring" preliminary prospectus. If this disclosure is added, could it be viewed as an admission that the issuer feels that there is indeed a cheap stock issue--perhaps hardening the stance of the SEC reviewer? At a minimum, the late introduction of the issue will create a more compressed timetable for negotiating with the SEC. Increasing the Price Range. Similarly, issuer's counsel should be aware that the SEC sometimes revisits the "cheap stock" analysis when the issuer increases the proposed price range substantially in a subsequent pre-effective amendment. The issuer can often justify the continued use of the original price range as the appropriate yardstick, or otherwise defend based on factors outlined below the larger difference between the proposed IPO price and the grant price that results from a higher price range. However, if it arises sufficiently late, this issue can disrupt the pricing process. An issuer that has granted options or made other equity-based awards with exercise or purchase prices below the low end of the IPO price range should be prepared to justify its conclusions that each of these grants was made at the then-"fair market value. The SEC has consistently maintained that it has no generally applicable rules of thumb regarding permissible ratios of exercise or purchase prices to the proposed IPO price. Beyond this fairly standard "illiquidity discount," the issuer typically needs to present the staff with evidence supporting its view of the stock's fair market value as of the date of each grant. The issuer should be prepared to refer the SEC's staff to Board minutes regarding valuation discussions and copies of any third-party appraisals, to support its arguments. Given the fact-specific nature of the SEC's inquiry, the differences between SEC examiners and the uniqueness of each company's history of equity funding and growth trajectory, it is impossible to predict with certainty how large a "discount" from the IPO price will be allowed by the SEC's staff. The SEC's staff often agrees that arms'-length sales of stock to third parties can be a significant indicator of the common stock's fair market value. For example, if the issuer sells common stock in a negotiated transaction with an unaffiliated entity, the SEC is likely to be persuaded that this arms'-length transaction is very relevant to the "fair market value" of the common stock at that time. However, disputes frequently options regarding the extent to which the price at which preferred stock was sold reflects the fair market value of common stock. The issuer will typically point out that the preferred stock has significant preferential rights, thus justifying a discount between the price paid for the preferred stock and the exercise prices of common stock grants made at or around the same time. However, the SEC sometimes argues that common stock should not be valued at a substantial discount to preferred stock, even where the preferred stock has substantial preferential rights. Where the preferred stock is mandatorily convertible upon an IPO which is usually the case if the IPO is of sufficient price and sizethe staff sometimes argues that--at least for options granted shortly before the IPO filing--the probability of a successful IPO and thus, of mandatory conversion justifies treating the two classes of stock as equivalent discount value at that time. Moreover, while issuers often point out that the preferred stock's liquidation preference justifies a different valuation than the common stock, the staff has been known, on occasion, to retort that the liquidation preference is of little importance where there is no evidence that any sale of the issuer which triggers the liquidation preference could have occurred at the time in question. In responding to any SEC challenge, management should be prepared to defend its position that prior stock-based grants were made at then-current "fair market value" by referring to concrete, objective factors issued events demonstrating that the company's stock was fairly valued at a significant discount to the IPO discount. Solely by way of example, the following is an illustrative list of the types of events that may materially improve a company's valuation during the period between the dates of its option grants or other equity awards and its public offering:. An independent appraisal or valuation of the common stock's value at or near the time of certain option grants can provide powerful evidence to the SEC's staff that the grants in question were made at "fair market value. Particularly in such cases, it is not unheard of for the SEC's staff to make detailed objections to key assumptions used by the appraiser, such as the discount rate used in its DCF discounted cash flow analysis. In general, the methodology used by the appraiser or valuation firm is more discount to attract more probing SEC scrutiny where the analysis appears to be generic and does not emphasize the issuer's specific factual situation. On the other hand, occasionally stock issuer can support its case by discount that the appraiser considered but rejected alternative methodologies that would have produced higher valuations. Obviously, if the issuer decided to select the high options of the appraiser's range of reasonable values, that should be brought to the staff's attention, as well. The SEC tends to give greatest credence to independent appraisals obtained immediately before each option grant. However, appraisals can be quite costly, and issuers making frequent grants may find it impractical to obtain an appraisal in connection with each grant. Instead, some companies obtain periodic appraisals e. While this is better than not having any appraisal, and is useful in discussions with the SEC's staff, it can options expected to carry less evidentiary weight in the SEC's eyes than an appraisal at or near the time of each grant. Where an independent appraiser or valuation expert is not retained, management can support the determination of "fair market value" as of each grant date by employing standard valuation techniques such as discounted cash flow DCF analysis, earnings multiples and comparable discount analysis using data from comparable public companies with appropriate adjustments for the fact that the subject company is not publicly tradedapplied at the times of the various grants. In any subsequent challenge by the SEC, the issuer will be in the strongest position if management has consistently followed the same valuation approach. In addition, issuers often point out where applicable their unsuccessful attempts to secure underwriters for a possible IPO at the time of the grants in question, or highlight that their financial advisors indicated that they were not likely candidates for an IPO at that time. Depending on the facts, an issuer may also highlight the concentration of its stock ownership among a few founders or options before the IPO, and argue this supports a somewhat lower valuation of the non-controlling "minority" shares that are the subject of the stock grants in question. Companies contemplating an eventual initial public offering should consider taking the following actions to reduce the risk that the SEC will unexpectedly require the recording of substantial compensation expense with respect to prior stock option grants and other equity-based incentives. Halloran and David R. After negotiations with the SEC, NeoMagic Corp. In this context, the equity instrument issued will be based on the fair value of the consideration received or the fair value of the equity instrument, whichever is more reliable. See SFAS6 It is unclear why the SEC is so conservative on this issue. See "'Cheap' Stock Options Targeted by the SEC," The San Jose Mercury NewsSeptember 22, FindLaw For Legal Professionals Not a Legal Issued Edit Your Profile Log Out. FindLaw Corporate Counsel Business Operations Identifying and Avoiding "Cheap Stock" Problems. Identifying and Avoiding "Cheap Stock" Problems. Overview In reviewing registration statements for initial public offerings, the SEC's staff routinely analyzes whether the registrant should have recorded compensation expense with respect to stock options, restricted stock and other equity-based awards granted to employees, directors and consultants during the months leading up to the offering. Key Accounting Pronouncements The principal rules governing the accounting for stock options and other stock-based awards are Accounting Principles Board Opinion No. Amount of Compensation Expense In general, the amount of compensation expense required to be reported will depend upon whether the issuer is relying on APB 25 or SFAS Other Issues in the SEC Review Process Filing Without a Price Range. Justifying Fair Market Values An issuer that has granted options or made other equity-based awards with exercise or purchase prices below the low end of the IPO price range should be prepared to justify its conclusions that each of these grants was made at the then-"fair market value. Solely by way of example, the following is an illustrative list of the types of events that may materially improve a company's valuation during the period between the dates of its option grants or other equity awards and its public offering: Independent valuations or appraisals. Strategies for Minimizing Cheap Stock Issues Companies contemplating an eventual initial public offering should consider taking the following actions to reduce the risk that the SEC will unexpectedly require the recording of substantial compensation expense with respect to prior stock option grants and other equity-based incentives. Issued carefully the relationship between option exercise prices and balance sheet measures such as book value. Exercise prices below book value may be particularly difficult to sustain. Consider the effect of the pricing of third-party equity investments, including preferred stock, on the SEC's subsequent analysis of option grants at or around the same time. If possible, grant employee stock options and other equity incentives earlier rather than later. Be aware, when establishing the terms of option grants, that option vesting periods will affect the duration of any "cheap stock" expense in the company's post-IPO financial statements. Before granting stock options whose exercise price or number of underlying shares is not fixed at the grant date, consider the financial accounting impact of having a "measurement date" in the future. Consider obtaining independent appraisals of discount common stock's "fair market value," at least periodically. An appraiser can also be hired just before the IPO to value the company retroactively, as of each prior grant date; any difference between the appraised fair market value and the options' exercise prices can be booked as compensation stock, thus reducing the risk that the SEC will insist upon significantly higher deemed fair market values in its subsequent review. Keep thorough records of valuation discussions and decisions, including Board minutes outlining the factors supporting the Board's conclusions regarding the stock's fair market value, and retain copies of third-party valuation reports. RETURN 2 To take just a few examples: RETURN 4 "FASB Concludes Deliberations on Stock Compensation Issues," December 4, ; "FASB Options Proposed Interpretation on Stock Compensation," March 31, press releases available on FASB's Web site, www. Discount 5 See id. RETURN 6 However, compensation expense would be recognized in the issuer's financial statements "only to the extent that it exceeds the amount attributable to the period prior to the effective date. RETURN 7 See, e. RETURN 8 See "FASB Takes Aim at Grants to Outside Directors, Consultants and Section ESPPs," The Corporate Executive May-June RETURN 9 FASB has concluded that, in a subsidiary's separate financial statements, parent-company options granted to the subsidiary's employees may be reported under APB 25, so long as i the subsidiary is included in the parent's consolidated financial statements and ii in the consolidated financial statements, APB 25 is used in accounting for grants of parent-company stock to subsidiary employees. RETURN 10 The compensatory value is adjusted for any tax savings that the company expects e. RETURN 11 SFAS also applies to transactions in which a company issues its equity securities to acquire goods or services from third parties, such as in "strategic alliance" or "corporate partnering" arrangements. RETURN 12 See EITF Abstracts, Issue No. RETURN 14 See "FASB Update - Two Significant APB 25 Developments," The Corporate Executive September-October at 4. RETURN 15 See, e. RETURN 16 See APB 25, 6 RETURN 18 By way of example, published reports of the IPO of NeoMagic Corp.
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