Companies that offer equity compensation must:

• 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
• Be aware of compliance requirements set out in Internal Revenue Code (IRC) Section 409A if incentive options are granted below fair market value

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 an IRC Section 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
• Management’s discussion and analysis disclosures (MD&A)
• The evolution of logical stock-value progression

It’s important to fully understand how the SEC will scrutinize your company’s equity compensation, valuations, and compliance. Issues 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.

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.

The lookback period can be two or three years in certain circumstances, such as large stock option grants before the 12-month time frame and changes in calculation technique or model chosen.

Authoritative Guidance

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—created by Staff Accounting Bulletin (SAB) No. 107 and updated by SAB No. 110. The interpretations of this guidance are applicable to companies seeking an IPO.

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).

The term 409A valuation typically refers to valuations performed for both tax and financial reporting purposes—IRC Section 409A and FASB ASC Topic 718, respectively.

Per IRC 409A, stock options issued with an exercise price less than the underlying common stock’s fair market value will result in compensation to the employee. Stock options issued with an exercise price greater than or equal to the common stock’s fair market value won’t result in compensation to the employee.

According to ASC 718, equity compensation must be recorded at fair value for generally accepted accounting principles (GAAP) reporting requirements.

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 approaches to help you estimate the value of your private company’s equity:

• Income approach
• Market approach
• Asset-based approach

While facts and circumstances may allow for only a limited number of approaches, all three approaches should be considered.

Most valuations of pre-IPO companies apply a combination of an income approach and market approach. As discussed below, an asset-based approach is rarely applied to pre-IPO companies.

This approach involves discounting the future expected cash flows of the company using a discount rate that incorporates the risk of realizing those cash flows.

The market approach encompasses several different pricing methods. This approach 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:

• Price to earnings
• 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 equals 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

The asset-based 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

Once an equity value has been established, this value may need to be allocated among different classes of equity.

In the case of a complex capital structure, which may involve preferred stock with different rights and preferences, 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.

As an IPO becomes more likely, the 409A equity value allocation method should evolve.

If a company 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, place an increasing amount of emphasis on the IPO scenario as the transaction draws closer.

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 can be necessary because private-company equity owners typically don’t enjoy the liquidity of freely traded public securities. Generally, 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. Methods used to estimate the DLOM should employ generally accepted models, and management should be able to reasonably justify the inputs.

A common approach is the protective-put model. This model employs a Black-Scholes calculation to determine the cost of a hypothetical put option to provide downside protection for the holder of the company’s stock.

Important inputs for this model include an estimated time until a possible liquidity event for the company, such as an IPO or acquisition, and anticipated volatility of the company’s equity value over the time period to liquidity.

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 specialists.
• 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.