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

The AICPA has issued guidance on acceptable valuation methods, which are heavily relied upon in practice. The most common fair value estimation techniques are the Market Approach and the Income Approach.

Depending on the stage of the enterprise and recent business activity, multiple valuation approaches may be used. For example, a company that recently completed a round of financing may determine a Backsolve Approach (a form of the Market Approach) to be most appropriate given the recent indicator of fair value. Alternatively, an enterprise with significant operations that has established more mature and accurate forecasting capabilities might employ a variety of valuation methods. Some examples include a discounted cash flow via the Income Approach or a peer company multiples analysis via the Guideline Public Company method (another form of the Market Approach).

Once enterprise value has been determined, it is important to note that equity value is not necessarily equally distributed among all shareholders or classes of shareholders depending on the company’s capital structure. The probability-weighted expected return method (PWERM), which considers various future liquidity events, is one common way to determine the equity allocation. The PWERM is a multi-step process where the probability of potential future outcomes is incorporated into the valuation model.

Prior to implementing a PWERM, companies often employ the Option Pricing Method. This method assumes the sale of a business at a future date and treats each security as a call option on the enterprise value with exercise price equal to cumulative liquidation preferences. Lastly, to the extent there have been secondary sales or tender offers, these transaction prices should be considered when determining common stock fair value within the valuation model.

As enterprise values may rapidly increase quarter-over-quarter, companies should interpolate the appropriate share value at the exact date of issuance of awards. An interpolation calculation is often applied to estimate the equity grant fair value at a date in between two common stock valuation reports. It is important to apply interpolation calculations to approximate the fair value of stock, or the stock underlying granted stock options or warrant. Fast-growing companies can experience rapidly increasing valuation reports period over period.

A company may risk understating share-based compensation expense if it relies on the most recent valuation report before the grant date, rather than retroactively applying an interpolation calculation. Interpolation calculations are common in practice and are often disclosed as methods for determining the fair value of grants on dates other than when a valuation report was received.

However, consider the trajectory of the fair value of the company and any significant milestones or events to determine if a straight-line calculation is appropriate. By performing interpolation calculations, companies can determine whether to revisit their initial assessments of grant date fair value and the related impact to stock-based compensation. The period in scope for the interpolation calculations includes all financial periods included within the registration statement, and all equity grants through the date of the IPO.

Companies often elect to preemptively address SEC concerns over the fair value of pre-IPO stock-based compensation awards by furnishing a “cheap stock letter.” This is usually done once an offering price range has been determined, shortly before the commencement of a roadshow. The goal of the cheap stock letter is to synthesize the valuation methodologies employed by management to value material equity grants (and related compensation expense) within a certain window leading up to the IPO (often a 12 to 18 month period).

Additionally, the SEC may scrutinize the disparity between the fair value of common stock in the company’s final valuations as compared to the IPO price range, and ask the company to reconcile the difference between them (for example, explain the events or factors that support the difference in values).¹ This results in a highly judgmental management analysis as to whether the company is exposed to a potential “cheap stock charge.”

^{1 - SEC Division of Corporation Finance, Financial Reporting Manual section 7520.1}