Cheap Stock Problems: What Triggers SEC Scrutiny

Cheap Stock: Understanding the Problem and What to Do About It

The scenario is familiar in successful private companies. A company grants stock options to its employees. Eighteen months later it files for an IPO at a price many times higher than the strike price on those options. The increase alone isn’t a problem. The issue is whether the company can defend the lower price as a fair value at the time of grant. If it can't, the company has what’s called a cheap stock problem, something that gets considerable scrutiny from both the SEC and external auditors.

Cheap stock versus a 409A problem

The terms “cheap stock” and “409A” are used interchangeably, and that's a mistake. They describe different issues.

A 409A valuation is a tax compliance exercise. Section 409A of the Internal Revenue Code requires a private company to set option strike prices at fair market value. An independent appraisal prepared using IRS-approved methods provides a rebuttable presumption of reasonableness (otherwise known as “safe harbor”). If the IRS later disagrees with the valuation, the consequence falls on the option holders, who face immediate income recognition on the deferred compensation plus a 20% additional tax.

Cheap stock is a GAAP and securities law problem, not a tax problem, and doesn’t affect individual recipients or result in specific financial penalties. Instead, it shows up when the SEC or the company's auditors decide that the fair value used for financial reporting under ASC 718 was too low, regardless of whether the 409A valuation qualified for IRS safe harbor. A company can have a clean 409A history and still get a cheap stock comment, requiring adjustments to expense.

Note that the 409A and ASC 718 stock prices typically come from the same appraisal. But the standard being tested is different, and clearing one doesn't guarantee the other clears. Indeed, the 409A standard of “not grossly unreasonable” is a significantly lower bar than an audit materiality threshold. We’ve seen many companies need to rework old analyses as scrutiny increases. For more information, check out the Hidden Costs of a Bad 409A Valuation blog for private companies.  

Why private companies carry more of this risk

As appraisers, our role is to try to estimate the value that something would sell for in a market transaction.

For public companies, the market sets a price. While arguments may persist about whether that price is fair, there’s no doubt that if you wanted to buy or sell the stock, the trading price provides objective evidence of value.

For private companies, the environment is different. There are few, if any, transactions involving the company’s stock. While we can look at the market for comparables, the company’s actual discount rates, market multiples, and the value of different rights in the capital structure require modeling, research, and judgment. Further, there may be a wide range of supportable outcomes, and reasonable appraisers can disagree on any of these inputs.

The cheap stock issue is fundamentally a hindsight problem. The question is whether the appraiser’s judgment holds up in light of subsequent events. As the SEC’s Division of Corporation Finance explains in Section 7520.1 of the Financial Reporting Manual, “If the estimated fair value of the stock is substantially below the IPO price, the registrant should be able to reconcile the difference between them (for example, explain the events or factors that support the difference in values).” In other words, if a company granted options at $2 per share one year before pricing an IPO at $15 per share, regulators expect a compelling explanation for that increase.

There are several legitimate reasons why the company value may increase significantly between valuation dates, including: 

• Unexpected growth in sales or earnings
• A successful product launch
• Regulatory approval for a life sciences product

On the other hand, the SEC and auditors want to make sure the difference is not the result of problems like:

• Reliance on stale or inaccurate data
• Overly aggressive assumptions that depressed value
• Inappropriate valuation methodologies

Public companies aren’t entirely immune from these concerns. In recent years, the SEC has increased its focus on equity awards granted while companies possess material nonpublic information, or MNPI. Staff Accounting Bulletin (SAB) 120 reminds companies that they shouldn’t automatically assume the market price is appropriate if they were in possession of MNPI on the grant date. Regulation S-K Item 402(x) also requires public companies to disclose option grants made in close proximity to the release of MNPI.

When the issue actually surfaces

Cheap stock is rarely discovered while a company is still private and not planning a liquidity event. Instead, it surfaces at three points:

• During the IPO registration process. The S-1 requires disclosure of all equity grants made during the roughly 12- to 18-month period preceding the filing, including the assumptions used to determine grant-date fair value.
• During the audit process. Auditors are required to evaluate stock-based compensation expense for every reporting period presented in the registration statement and will push back before the SEC ever sees the filing.
• Through SEC comment letters. SEC staff specifically looks for unusually steep increases in per-share value leading up to an IPO and asks registrants to reconcile differences between historical valuations and the offering price.

What happens if the SEC doesn't agree

If the SEC staff concludes that grant-date fair values were understated, the company doesn't get to argue the point away. It has to recognize additional stock-based compensation expense for the affected periods: a cheap stock charge.

Because this expense wasn't budgeted or modeled into the deal, it can easily be large enough to distort reported earnings for the periods under SEC review. If financial statements are already filed, this adjustment can mean a restatement, which brings its own disclosure obligations and invites the exact investor scrutiny a company preparing for its public debut is trying to avoid.

Beyond the accounting mechanics, a cheap stock finding surfacing during the IPO window signals to underwriters and prospective investors that the company's internal controls around equity valuation weren't solid. That's a bad story to be telling in the weeks before pricing a deal, and it can slow the registration timeline at the point where delay is most expensive.

Reducing the risk before it's a live issue

The fix is mostly about frequency and documentation, not sophistication. Companies can stay ahead of the problem by:

• Updating valuations when significant events occur. Any event affecting the company’s value (like a financing round, major commercial milestone, or material change in the cap table) warrants a new valuation rather than waiting for the next annual update. We often see companies approaching their IPO move to quarterly valuation assessments.
• Working with a qualified independent valuation firm. A valuation is only as strong as its underlying analysis. Key assumptions, methods, and judgments should be well documented so the story behind each number survives regulatory review in future years.
• Documenting moves between valuation dates. Don’t leave changes in value, especially larger ones, unexplained. They should be clearly tied to identifiable business developments.
• Establishing good practices early. The SEC’s 12- to 18-month look-back period means the valuations that get the most scrutiny are probably already delivered by the time bankers show up. By then, the record either supports the story or it doesn't.

In the end, the best defense against a cheap stock issue is a consistent valuation process supported by contemporaneous analysis. When the facts, assumptions, and documentation clearly explain how enterprise value evolved over time, companies are in a much better position to withstand the heightened scrutiny that accompanies an IPO.

For more resources, visit the Private Company Stock Plans section on NASPP.com.