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Issuing equity pre-IPO? Address “cheap stock” concerns now to help avoid SEC scrutiny later

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Observations from the front lines

Background

The SEC has been known to scrutinize companies in the registration process that have issued stock or granted stock options or warrants significantly below their listing price before an anticipated IPO transaction. With equity being a popular form of compensation for many pre-IPO companies, so-called “cheap stock” can create issues that may emerge when companies are going public.

Cheap stock

Why it matters

Implications for pre-IPO companies stretch across financial reporting, tax compliance and the registration statement filing timeline, as SEC scrutiny can be an obstacle late in the SEC filing process. Companies that become entangled in cheap stock issues risk delays in their IPO or stock listing and may be required to take a cheap stock charge, which is an incremental and often unforeseen stock-based compensation expense. Additionally, the company’s external auditors will also evaluate stock-based compensation expense for all periods presented within the registration statement to evaluate appropriate recognition of charges and ensure expenses are not understated.

Dealing with the SEC

The SEC typically scrutinizes valuation of stock-based activity in the period 12-18 months prior to the IPO. However, this period could be longer based on the facts and circumstances. Filers should disclose the methods that management used to determine fair value, the nature of the material assumptions and the extent to which estimates are considered highly complex and subjective.

It is important to explain the price changes over time, relative to material equity grants, especially describing those events that led to significant increases in valuations shortly before the expected IPO. The final common stock valuation should be reasonable, compared to the IPO price range.

Companies often take a preemptive approach to SEC review by submitting a stand-alone “cheap stock letter.” Registrants that do not furnish a cheap stock letter may be more likely to receive a comment letter from the SEC.

Common areas of discussion in the cheap stock letter

Cheap stock letter
  • Methods for determining common stock fair value and the nature of material assumptions
  • Range of pricing in prospectus versus historical valuations
  • Key milestones in the company’s development (e.g., revenues, profitability, milestones, key hires)
  • Timing of valuations performed (contemporaneous or retrospective)
  • Valuation approach and weighting
  • Determination of comparable companies
  • Discount for lack of marketability
  • Weighting of secondary transactions

The bottom line

Potential cheap stock concerns include many complexities that could significantly impact a company’s overall registration timeline. To avoid delays, be sure to identify and address any potential concerns early in the going-public process. PwC can help guide you through compliance from a financial reporting, tax, and valuation perspective.

At a glance: Key considerations

  • Assess material equity grants approximately 12 to 18 months before the offering to assess common stock valuations that are significantly lower than the offering/listing price.
  • Proactively provide detailed disclosure in a cheap stock letter to the SEC.
  • Obtain third-party valuation reports concurrent with significant financings or material grants, at least on a quarterly basis leading up to the listing.
  • Determine the appropriate time to consider moving to a PWERM allocation methodology.
  • Appropriately consider secondary transactions and tender offers in the valuation.

“Observations from the front lines” provides PwC’s insight on current economic issues, our perspective regarding the financial reporting complexities and what companies should be thinking about to effectively address those issues. For more information, visit www.pwc.com/us/cmaas.

Observations from the front lines

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Mike Bellin

IPO Services Co-Leader, PwC US

Samantha Zytko

Director, Deals, PwC US

Erik Samuels

Senior manager, Deals, PwC US

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