Preparing for an initial public offering (IPO) is a significant undertaking for all private companies, but it can be especially challenging for those that offer equity compensation to employees.

Equity compensation is an essential tool for recruiting and retaining talent—especially for companies that want to build a strong management team before going public. However, while equity compensation is a powerful incentive that makes more cash available for other business needs, it creates additional financial reporting requirements.

Fully understanding these requirements and preparing for a valuation well in advance can greatly ease the IPO process. Following is an overview of key requirements and steps your company can take to receive a valuation, remain compliant, and successfully enter the public market.

Requirements

Companies that offer equity compensation must do the following before an IPO:

• Perform a valuation of company stock so the cost of equity compensation can be recognized at the grant-date fair value, as set out in the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 718.
• Report for tax purposes the fair market value of stock issued for compensation, as specified in Internal Revenue Code (IRC) Section 409A.

Fulfilling these requirements can be complex, so it’s useful to know how the SEC will review your company’s compensation as well as how to obtain an estimate of your company’s value before a 409A review. Here are four key areas companies should understand before receiving a valuation:

• SEC authoritative guidance relating to equity compensation
• Common 409A valuation approaches and inputs
• The evolution of logical stock-value progression
• Management’s discussion and analysis disclosures (MD&A)

Following is an in-depth overview of each area.

SEC Authoritative Guidance

As part of its review of filings for an IPO, the SEC will analyze a company’s awards and valuations from a 12-month period prior to the IPO date. In certain circumstances, such as large stock option grants before the 12-month time frame and changes in calculation technique or model chosen, the lookback period can be two or three years.

During this review, the SEC will typically focus on what’s known as cheap stock, which are stock-based awards given as compensation. It will then address rules and regulations regarding valuation of share-based payments for public companies in Topic 14, Share-Based Payment, of the SEC’s Codification of Staff Accounting Bulletins, which was created by Staff Accounting Bulletin (SAB) No. 107 and updated by SAB No. 110. The interpretations of this guidance are applicable to companies seeking to become public.

The SEC will also analyze previously performed valuations and how well they comply with authoritative guidance on valuing stock of private companies—such as the American Institute of Certified Public Accountants (AICPA) guide on the Valuation of Privately-Held-Company Equity Securities Issued as Compensation (AICPA Guide).

It’s important to fully understand how the SEC will scrutinize your company’s compensation, valuations, and compliance because issues arising in these areas could lead to subsequent accounting changes and financial statement corrections that will delay the IPO process and possibly have negative tax repercussions for option holders.

409A Valuation Approaches and Inputs

Before an IPO, all private companies should obtain a 409A valuation when stock options are granted. This valuation is an independent appraisal of the fair value (FV) of a private company's common stock.

There are several ways to approach a 409A valuation, and each can help you estimate the value of your private company’s equity.

Approaches

Income Approach

This method involves discounting the future expected cash flows of the company that are expected by the equity holders. It uses a discount rate that incorporates the risk of realizing those cash flows.

Market Approach

The market approach encompasses several different pricing methods. This method utilizes market-derived pricing multiples taken from a group of comparable publicly traded companies or recent transactions in private companies. These pricing multiples might include the following:

• Earnings per share (EPS)
• Enterprise value to earnings before interest, taxes, depreciation, and amortization (EBITDA)
• Enterprise value to revenue

Another example of a market approach considers the implied value for common stock based on the most recent round of financing. This approach, known as a backsolve method, involves modeling the rights and preferences of the various classes of equity and adjusting total equity value until the amount allocated to the stock sold in the last financing round is equal to its negotiated issuance price.

The market approach should also consider expected IPO price ranges for a company as determined by the company’s investment bankers.

Asset Approach

The asset approach involves adjusting assets and liabilities to a fair market value to estimate the fair value of the company’s equity. This approach isn’t commonly used for pre-IPO companies because it doesn’t capture a company’s intangible asset value. Common intangible assets include a company’s developed technology or other intellectual property, established customer base, and positive brand recognition.

Equity Allocation

Once an equity value has been established, this value will need to be allocated among the different stockholders. In the case of a complex capital structure, which may involve preferred stock with differing levels of seniority, an allocation method will be required. Some of these methods include the following:

• Option pricing method (OPM)
• Probability weighted expected return method (PWERM)
• Hybrid method—a methodology that incorporates a PWERM and the OPM

Learn more about how to apply allocation models in the AICPA Guide.

Discount for Lack of Marketability

Once the marketable value of the common stock is determined, an additional adjustment is often required—the discount for lack of marketability (DLOM). This discount is often necessary because private-company equity owners typically don’t enjoy the liquidity of a freely traded public security. Typically, the DLOM declines as a company nears a liquidity event such as an IPO.

Measuring DLOM can involve highly subjective inputs, which often receive scrutiny from the SEC and a company’s auditors.

Valuation Approach Adjustments

As an IPO becomes more likely, the 409A valuation approach should evolve. If a company has historically used a PWERM to allocate equity value, greater weight will likely be placed on the IPO scenario as it draws near. If an OPM was historically used to allocate equity value, a company may transition to the hybrid method that incorporates an IPO scenario.

Regardless of which method is used, an increasing amount of weight should be placed on the IPO scenario as the transaction draws closer.

Additional Value Indicators

Other value indicators, such as private placements or other transactions in the company’s securities, often come into play as a company nears an IPO. Any transactions in the company’s equity securities should be evaluated based on considerations set forth in the AICPA Guide and weighted appropriately. The weighting applied to these transactions is subjective, and all of the factors considered in arriving at the weighting should be detailed in the valuation report.

Investment-Banker Valuations

Early in the IPO process, a company may engage investment bankers to complete the IPO. The investment bankers often provide a presentation in which they estimate the value of the company on the IPO date.

Guideline Companies

The professional performing the 409A valuation should understand which comparable companies and valuation measures the investment bankers select in their valuation. Entities selected as guideline companies in the 409A valuation should be similar to those used by the investment bankers.

If the valuation professional selects different entities as guideline companies, they should be able to articulate why different entities were selected. The value implied by the investment banker shouldn’t necessarily be utilized in the 409A valuation, but differences in the two values should be explainable.

Key Differences

One of the significant differences between the investment banker valuation and the 409A valuation will likely be the DLOM. The investment banker valuation won’t include a DLOM. The 409A valuation, however, will include a DLOM because the company’s equity securities aren’t yet marketable.

Before the IPO is contemplated, the DLOM can be significant. As a company nears the IPO date, there should be a steady decline in the DLOM. The DLOM is typically determined using quantitative models that determine the cost of a hypothetical protective put option that spans the time until the securities become marketable.

MD&A Relating to Valuations

Valuations that include full discussions of valuation techniques, significant factors, and assumptions can be very beneficial when a company is preparing the MD&A disclosures required in SEC filing documents.

These components aren’t always present in hastily performed or abbreviated valuation reports. However, they can help management prepare an effective discussion about the appropriateness and accuracy of fair values assigned to stock-based grants as well as paint a cohesive picture of company developments that have led to changes in value between grant dates and the estimated IPO price.

When preparing MD&A disclosures, the SEC’s list of generally asked questions about compliance and disclosure requirements can help companies resolve related questions.

Next Steps

After gaining a comprehensive understanding of potential valuation approaches, it’s time to begin the process.

If your company is considering an IPO, it’s important to select a valuation professional with significant experience valuing pre-IPO companies for 409A. In many instances, your financial statement auditor can provide a referral. Selecting a professional who doesn’t have proper experience or who uses improper methodologies can result in significant additional audit costs or a challenge from the SEC.

Before selecting a valuation professional, companies can benefit from taking the following steps:

• Schedule a meeting with the valuation professional and your auditor, including their valuation experts.
• Discuss the methodologies the valuation professional expects to apply and obtain auditor agreement.
• Establish an agreement that the valuation professional will reconnect with you and your auditors if the agreed-upon methodologies deviate from the original plan.
• Request a draft of the valuation so your auditors can review it and provide questions or feedback before the valuation is finalized.

Changes in Value

Over the two-to-three years leading up to an IPO, it’s comforting to see a steady increase in common stock value to the eventual IPO price, though it isn’t necessary. However, changes in value must be explainable based on the following factors:

• Changes in the economy
• Industry trends
• Company finances
• Market trends

Rapid increases in common stock value just before the IPO and significant gaps in value from the eventual IPO price will likely result in more SEC scrutiny.

Your company’s valuation should detail factors considered during the valuation and tell a story about how the value was derived. This detail is especially important because any scrutiny is likely to take place after the valuation date when the IPO is already in process.  

We’re Here to Help

Planning for your IPO can be challenging, but adequate preparation with IRC 409A valuations can greatly ease the process. To learn more about the process or get started with your company’s 409A valuation, contact your Moss Adams professional.