IPO and Stock Compensation: What to Expect While You’re Expensing

Going public is always an exciting (albeit laborious) time for any firm. But the current renewed interest and optimism in the IPO market makes the prospect doubly enticing. And no wonder. In 2013, more than 220 companies based in the US alone completed IPOs. And from January 2014 through to the end of March, 64 companies went public, raising almost $11 billion. By any measurement, it’s the healthiest quarter we’ve seen since 2000.

While the enthusiasm is understandable, firms that compensate their talent with equity have additional diligence items to add to the already-Herculean IPO to-do list. If “equity comp” is last on your list, read on. Sure, it’s not the sexiest of topics related to IPO, but face it. Stock compensation is a highly regulated practice, and private firms are simply not accustomed to the level of scrutiny that will come from regulators, shareholders, proxy advisory firms and the media upon going public. And much of the work falls on the finance folks. Check out our list of “gotchas” to make sure you don’t get pinched.

Welcome to stricter valuation methods

As a private company, you enjoyed unmatched flexibility in valuing your grants for compensation expense purposes. Using valuation models such as Black-Scholes to value your grants had been optional and often tricky, at least in your early days, as determining the price volatility assumption might have been problematic. You may have been able to establish an estimate based on your internal market and private transactions. If sufficient historical information was not available, you had the option to use the calculated value, which allows companies to use an industry-appropriate index in place of the price volatility assumption. This approach is not without its risks, as both the industry and the size of your company must be taken into consideration. Furthermore, if your company was categorized in more than one industry, you had to ascertain a weighted average using multiple relevant indices.  Finally, if the calculated value approach proved prohibitively complex, you could instead use an intrinsic value to calculate compensation expense. Assuming you were issuing at-the-money options, your equity compensation program would never result in compensation expense. Lucky you!

But. But. But. Unless your company has grown at a prodigious pace, you really should have already switched to an option-pricing model by the time you’re in the IPO readiness phase. At that stage, most firms have the historical data required, which hopefully is something your auditors have mentioned.

Get acquainted with option-pricing models

That is, if you haven’t already! As a public company, you must follow an approved option-pricing model, such as Black Scholes. In all cases, your MD&A must include all changes in accounting policies upon going public, including your valuation calculation methods. While you do not have to revalue your pre-IPO grants upon going public if there are no changes to their terms, new grants must be valued using a valid option pricing model. If there are changes to the terms of your pre-IPO grants, they will be revalued twice – first at the latest calculated (or intrinsic) value and again at a fair value calculated using an option pricing model. These changes must go into effect as soon as you file an initial prospectus to sell your securities.

Avoid “cheap” moves

You should rethink your option pricing 12 – 18 months prior to your IPO in order to avoid suspicions of issuing “cheap stock.” The SEC can – and will – scrutinize recent issuances for hints of improperly priced options in the period leading up to your IPO. The SEC looks for issuances at an exercise price considerably lower than your IPO price. These types of issuances may not be considered “cheap stock” if you can point to a specific event that caused a drastic price change over the short time frame, or if that time frame wasn’t so short after all. However, if it is determined that you issued in-the-money options as opposed to at-the-money options, you must record a “cheap stock” charge equal to the difference between the exercise price and the IPO price.

Get duly frequent 409A valuations

To avoid cheap stock issues, you should obtain frequent 409A valuations in the period leading up to your IPO. Begin using an independent appraiser and document the methodology used to value your grants in the early stages of preparing for your IPO. Be sure to choose a firm wisely; the IRS has rejected 409A valuations due to methodological objections. Frequency is also key. Best case scenario? Get a new valuation for each grant date and avoid granting awards when a new valuation is pending.

Watch out for admin stuff

Changes and oversights at an administrative level can have implications for the finance team at IPO. Your HR colleagues may want to explore the plans beyond vanilla options – many of which can be powerful recruitment and retention tools. Just take note of the tax and accounting consequences!

  • Consider introducing an Employee Stock Purchase Plan (ESPP) as a way to encourage broad-based employee ownership. A Section-423 qualified ESPP comes with its own taxation and accounting considerations.
  • Performance awards may seem like a useful tool in compensating your executives, but they may introduce the need for probability accounting or more complex valuation models, such as the Monte Carlo Simulation.
  • With the added capital, you have the flexibility of adding cash-settled grants, such as RSUs, which come with the additional complexity of liability accounting.

Pay attention to your ISOs

Another mutual administrative/finance pain point relates to ISOs. In our experience, many privately held companies don’t calculate the $100K limit correctly. This is one frequent area of regulatory scrutiny at IPO that carries a financial penalty. A good scrubbing can catch this prior to IPO. Portions of ISOs that exceed the $100,000 max are taxed as non-qualified stock options. You will need to withhold taxes and report the gain on any exercise of shares that exceeds the limit. This includes your company’s matching FICA and FUTA payments (if applicable). Penalties for not withholding the appropriate taxes can be up to 100% of the amounts that should have been withheld, can include interest and other administrative fees, and, in extreme cases, can involve criminal penalties. Additionally, by not properly reporting the income realized by employees upon exercise, your company won’t be able to claim the tax deduction on that income.

 There’s going public – and then there’s being public

As a public entity, your company will be responsible for a variety of additional disclosures. You will need to calculate and report on Basic as well as Dilutive Earnings per Share (EPS), per ASC Topic 260. There are additional disclosures required for your Forms 10-Q and 10-K, including the number of exercisable outstanding options, as well as the weighted average exercise price of those options.  And that’s just the beginning. There are countless resources available on all facets of stock plan administration at a public company. If you haven’t done so already, get acquainted with industry organizations like the NASPP, CEPI and GEO.

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