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.
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.
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.
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.
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