Cheap Stock - Frequently underwriters will have need of a company

When a company prepares to go public through an Initial Public Offering (IPO), the valuation of its stock and any equity grants to employees or executives comes under intense scrutiny. "Cheap stock" refers to the practice of issuing stock options or other equity awards at a price significantly below the fair market value shortly before an IPO. This can create accounting complexities and raise red flags with regulators like the Securities and Exchange Commission (SEC).

What is "Cheap Stock" in an IPO Context?

"Cheap stock" describes the practice where a company issues stock options or other equity awards to its management, employees, or consultants at an exercise or purchase price that is considerably lower than the fair market value of the underlying stock. This often occurs in the months leading up to a company's IPO.

Underwriters, who help a company go public, sometimes require additional qualified management. To attract these individuals, companies might offer stock options with a very favorable, or "cheap," exercise price. While this can be a legitimate incentive, the SEC closely examines these grants to ensure they are properly valued and accounted for.

How Does the SEC Scrutinize Stock Grants?

During the registration process for an IPO, the SEC staff meticulously analyzes whether the company should recognize compensation costs related to stock options, restricted stock, and other equity-based awards granted to employees, consultants, and directors in the months preceding the offering. This area has received increasing attention from the SEC in recent years.

Generally, the SEC requires an 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 a company has a significant number of below-market options or other stock-based grants (often referred to as "cheap stock"), the resulting compensation expense can negatively impact the planned IPO or, at a minimum, create an unexpected drag on future earnings. In some cases, underwriters may need to explain an unanticipated earnings charge related to this compensation when marketing the offering, especially if investors are focusing on metrics other than reported income.

Key Accounting Standards for Stock Options

Historically, the principal rules governing the accounting for stock options and other stock-based grants included:

• Accounting Principles Board Opinion No. 25 (APB 25): "Accounting for Stock Issued to Employees."
• Financial Accounting Standards Statement No. 123 (SFAS 123): "Accounting for Stock Based Compensation."

Amidst increasing scrutiny of executive compensation by institutional shareholders, investors, and the public in the early 1990s, the Financial Accounting Standards Board (FASB) issued a contact draft for a new standard on accounting for stock options in 1992. FASB focused on the shortcomings of APB 25's valuation approach, which only considered the option's intrinsic value and not other factors like the time value of money or the right to purchase stock over an extended period.

After significant public controversy and discussion, FASB issued SFAS 123 in 1996. SFAS 123 encouraged companies to account for employee stock options using a fair value valuation method. The application of these foundational rules continued to evolve, complicating companies' efforts to predict how the SEC would analyze their specific situations. The FASB also worked on interpretive guidance to address what it observed as diverse practices among companies accounting for employee stock options under APB 25.

How Far Back Does the SEC Look?

The SEC typically scrutinizes options granted or other equity-based awards made within one to one-and-a-half years preceding the filing of the registration statement. However, this timeframe is not absolute. It is not uncommon for the SEC to request information about grants and awards going back as far as three years. The SEC staff does not follow a formal prototype or principle, nor does it provide specific guidance on the exact look-back period in this area.

Frequently Asked Questions

What should a company do if it has issued "cheap stock" before an IPO?

Any company planning an IPO that has issued options or other stock-based grants in the preceding one to one-and-a-half years at exercise or purchase prices below the low end of the expected public offering price range should prepare a defensible "cheap stock" analysis. The issuer should be ready to justify its determination of the stock's fair market value as of each grant date, often by referring to objective data.

How can a company strengthen its position regarding "cheap stock" valuations?

A company can often strengthen its position by referring to the stock prices that third-party investors paid at or around the time of the awards in question, to any independent appraisals conducted at or just about that time, and to significant milestones achieved or other changes in the business since the award date.