Cheap Stock: Documenting Option Grants Before an IPO

Equity grants made in the year or so before an IPO get some of the closest scrutiny in the whole registration process. When the value used for those grants is far below the price the company lists at, the SEC staff usually asks why. Accountants call this the "cheap stock" question. Here is what it is, why it matters, and how to document grants so the answer is ready.

What "cheap stock" means

Stock compensation expense under ASC 718 is based on the fair value of the award on the grant date. Private companies usually set that value with an independent valuation, often a 409A valuation. If the company then prices its IPO well above the recent grant values, the gap can suggest the grants were made at less than fair value, so the expense in the financial statements was too low.

Why the SEC staff asks

When the expected offering price is known, the SEC staff commonly asks the company to explain how it determined the fair value of the common stock behind its recent equity grants and why those values differ from the offering price. The review usually covers grants from roughly the 12 to 18 months before the IPO, and can reach further back when there were large grants or changes in valuation method.

409A value versus accounting value

A 409A valuation is a tax matter: it supports an exercise price that avoids penalties under Section 409A of the Internal Revenue Code. The accounting question is whether the fair value used under ASC 718 holds up. A valuation can meet the tax safe harbor and still be challenged for financial reporting, for example if it ignored a financing round or a milestone that had already changed the company's value.

What a good file contains

• A timeline of value-changing events: financing rounds, product launches, major contracts, clinical or regulatory milestones, key hires, and the start of IPO discussions
• A valuation for each grant date, or an explanation of why a recent valuation still applied, prepared under the AICPA's guide on valuing privately held company equity
• A bridge from each valuation to the next, and from the last one to the expected offering price
• The grant records: board approvals, grant dates, numbers of shares, and exercise prices that match the cap table
• An accounting memo that brings it together and supports the expense recorded

Working with your valuation firm

The valuation firm sets the values; the company's accounting team, or an outside accounting firm, decides how they are used in the financial statements and documents the reasoning. Share the timeline of events with the valuation firm when each valuation is prepared, not after the fact, so the valuations reflect what management knew at the time.

Common mistakes

• Granting a large batch of options shortly after a financing at a valuation that predates it
• Relying on a stale valuation while the company's prospects changed quickly
• Board minutes and grant dates that do not match the option ledger
• Rebuilding the explanation only when the SEC comment letter arrives

Our Technical Accounting Advisory team prepares cheap stock analyses and stock compensation memos with your valuation firm, and our IPO Readiness Accounting service reconciles the equity records behind them. For the wider picture, see how accounting problems delay an IPO.

Frequently asked questions

Will we have to restate stock compensation expense?

Only if the analysis shows the grant-date fair values used were not supportable. A well-documented file often answers the SEC staff's questions without changing the numbers.

Should we stop granting options before the IPO?

Not necessarily. Keep granting if the business needs it, but get a current valuation for each grant and document the events that affected value.

Who should prepare the cheap stock memo?

Management owns it. Many companies use an outside accounting firm to prepare it with the valuation firm, and the auditor then evaluates it.

General information only, not tax, accounting, or legal advice.