Cheap Stock -
A Small But Important Part Of The IPO Process
When a Company awards restricted stock or stock options to key employees, the appropriate standard of value is Fair Market Value (“FMV”). This is an income tax issue for both the employee and the company. Unfortunately, many firms anticipating a public offering fail to properly document the FMV of their securities. If options or stock were awarded at prices below FMV, the company will face a cheap stock issue with the SEC. Financial statements will have to be revised with a consequent charge against earnings to reflect previously unrecorded compensation expenses. A large compensation charge will impact earnings and could even derail an IPO.
What Can be Done?
A contemporaneous valuation by an independent expert can offer a strong defense against cheap stock allegations. When a company begins to consider the possibility of an IPO, and particularly once the firm is within a year or eighteen months of the prospective underwriting, the firm or its auditors should request an independent business valuation to determine and document the FMV of all stock awards and options which were granted. A lack of such documentation can subject the offering to delays, or worse.
For example, in 1995, a technology company's planned IPO was delayed because of cheap stock issues. The Board engaged an independent valuation firm to determine and document the historic FMV, as of the date of each round of stock option awards. The charge for unrecorded compensation was quantified at a lower amount than alleged and the IPO took place when the market next allowed. With his next IPO-bound venture, that same CEO vowed not to put his company at similar risk. The same firm was brought in early to determine the FMV of Incentive Stock Option awards well in advance of the successful IPO.
What is Market Practice?
Companies are reacting in one of three principal ways. Some IPO hopefuls are setting the option's strike price at the same pricing as the preferred stock during the early rounds of investment or at the expected offering price, when the offering is close and the underwriter can estimate a pricing range. This very conservative decision minimizes the compensation question, but also penalizes the value of what the key employees have been awarded. A second (and the largest) group overlooks the issue until it becomes a problem. The third group, who are aware of the potential problems, start early and secure an independent valuation for each round of stock option awards.
How Does the Valuation Work?
It begins with established valuation methodologies: guideline company analysis; guideline acquisition analysis; and discounted cash flow analysis. These widely accepted approaches work well for most companies. In other cases, traditional approaches won't work, perhaps because the company couldn't provide a business plan or was not able to provide detailed forecasts. In these cases, less traditional methods can be used to determine the FMV of the stock. The FMV standard, as set forth in Revenue Ruling 59-60, is the price at which a willing buyer and a willing seller would trade, neither being under any compulsion to act, with each having the same information. Note that, in the absence of a market transaction, there may not be a “right” answer. However, the conclusion of value must be reasonable, logical and defensible.
Piggyback on Venture Rounds
One or more rounds of venture investments, typically in Preferred securities, may set a starting point for determining FMV. These venture investments represent market transactions between a willing buyer and a willing seller. Adjustments can be made to reflect the differing characteristics between the Preferred and those of the Common Stock. For example the Preferred often has superior dividend rights, preferences in liquidation, voting rights, board representation and registration rights, among others. The Common Shares most often lack these rights and would sell at a quantifiable discount to the Preferred. In order to address the periods between venture rounds, adjustments might be applied based on the company's progress in meeting or failing to meet certain milestones.
When the underwriters have announced an expected offering price range there are still discounts which may be applicable. For instance, markets can turn hostile quickly and unfavorable developments, e.g. lawsuits, etc., can occur causing the offering to be uncertain until it actually takes place. Additional discount adjustments may be applied to reflect a lack of marketability both before the offering and after, i.e. lock-up restrictions.
Planning Opportunities
In addition to removing a potential roadblock to a public offering as a result of SEC or IRS scrutiny and a charge to earnings for unrecorded compensation, a number of excellent planning opportunities exist for holders of founders' stock, restricted stock and stock options. Transferring securities into Grantor Retained Annuity Trusts or into Family Limited Partnerships with subsequent gifting programs are very effective planning techniques, but again they must be thought of well in advance of the IPO.
Conclusions
Today, the IRS and SEC are watching IPO filings more closely than ever before. In support of a successful IPO, a company and its advisors should seek out an independent business valuation firm to determine the FMV of stock awards and stock options for each round of grants. This will reduce the possibility of challenges on the issues of cheap stock or unrecorded compensation and help to ensure that there are no delays in the IPO. The FMV can be determined by using the established valuation methodologies or less traditional approaches. The independent business valuation firm can also assist the company's advisors in explaining a number of valuable planning opportunities for stock option holders.
©2001-The Baker-Meekins Company, Inc.
The Baker-Meekins Company, Inc. is an independent business and securities valuation firm, which has operated in Maryland since 1987. Along with providing business valuation services on incentive stock option plans and employee stock ownership plans, the firm also works on federal gift and estate taxes and the business and ownership strategy needs of business owners and their advisors.