Accounting for Stock-based Compensation
An overview of accounting for stock-based compensation is helpful to understand the issues surrounding cheap stock. Stock-based compensation is a complex area of accounting addressed in Accounting Standards Codification (ASC) 718. The accounting standard topic addresses measurement, classification, and recognition of all types of stock- or share-based compensation, including restricted stock and stock options.
The basic treatment of stock-based compensation includes determining the fair value of the compensation at grant date, then recognizing the value as compensation expense ratably over the vesting period. The following provides a simplified stock-based compensation example:
PE Dream, a new technology company, has optimistic expectations about the company’s future. However, cash funds available to pay computer programming employees is limited. To compensate these employees, PE Dream began a stock option award program that would give each of its eight programmers options to purchase 500,000 shares at a strike price of $11. The award vests over three-years. Using the Black-Scholes model, PE Dream estimates the value of awarded options to be, in aggregate, $3,600,000 at the grant date. PE Dream will recognize $1,200,000 in compensation expense each of the three vesting years ($3,600,000/3 years = $1,200,000), as shown below:
|Grant Date||Year 1||Year 2||Year 3|
|Compansation Expense||$0||$ 1.2M||$ 1.2M||$ 1.2M|
As shown above, the fair value estimate of the stock-based instrument (in Example 1, stock options) made at grant date determines the total level of compensation expense that will be recognized over the vesting period. As such, the valuation is a critical element of correctly expensing such compensation.
Determining a correct valuation estimate can be difficult for private companies for many reasons such as the following:
- Lack of a ready market for its stock and infrequent stock sales
- Infrequent valuations due to the high cost of such valuations and the company’s constrained resources
- Rapid fluctuations in firm value
- Unsophisticated systems and/or documentation
This difficulty in producing an accurate valuation for its stock options and other stock-based compensation instruments often lead to a problem known as cheap stock.
The Cheap Stock Issue
Cheap stock is when a company significantly undervalues its estimate for stock-based compensation at the grant date. Typically, cheap stock applies to significantly undervalued awards granted within one year of an IPO. For example, assume a company grants restricted stock at $4 six months before an IPO. At the IPO date, the shares are valued at $15 per share. This increase of 275% may be unreasonable and may indicate a cheap stock exists.
Cheap stock can draw scrutiny from the Securities and Exchange Commission (SEC), especially when filing an initial public offering. The SEC addresses the issue in its Financial Reporting Manual (FRM):
“The staff may issue comments asking companies to explain the reasons for valuations that appear unusual (e.g., unusually steep increases in the fair value of the underlying shares leading up to the IPO). These comments are intended to elicit analyses that the staff can review to assist it in confirming the appropriate accounting for the share-based compensation… [emphasis added]” (FRM, 9520.2)
Valuations determined to be below fair value indicate understated stock compensation expense. The purpose of ASC 718 is to reflect the economic outflow of value when stock-based instruments are awarded to employees as compensation. So, with valuations below fair value, the company does not reflect economic outflows, which is misleading to investors. Compensation expense is understated and earnings are overstated. If the SEC states valuations are not reasonable, the company must adjust compensation expense. This adjustment lowers earnings.
Cheap stock may also have tax implications. If cheap stock is an issue, taxation on employee stock options may be wrong. But corrections are not required unless the value is “grossly unreasonable.” So, companies may not need to correct their taxes even when GAAP corrections are necessary. See our article on 409A Valuations, which are used to meet Internal Revenue Code (IRS) requirements for setting strike prices of stock option compensation.
What Can Companies Do?
Depending on where a company is along the timeline to an IPO, its managers can take various actions to avoid or address the cheap stock issue. Generally, companies can avoid SEC and IRS scrutiny by obtaining a reliable valuation and maintaining appropriate documentation. When there is a significant difference between the share price estimate at the grant date and the IPO date, the SEC expects firms to “…be able to reconcile the difference between them (for example, explain the events or factors that support the difference in values)” (FRM, 7520.1).
Management should consider the following recommendations below to avoid cheap stock issues.
Plan and budget more frequent valuations
Due to the rapid, volatile growth in pre-IPO equity valuations, these companies should plan for more frequent valuations. The company should avoid performing these valuations retrospectively from the grant date. Instead companies should perform valuations contemporaneous with the grant date to provide a more reliable estimate of value as of a specific date. These reliable estimates are strong evidence when responding to SEC comments. The SEC also considers the objectivity of the valuations specialist to determine the reliability of estimates. So, these valuations are best when performed by independent third-party specialists.
409A valuations, as required for options pricing, are likely already occurring. Companies may consider using 409A valuations for grant date valuations, when possible, to reduce costs.
Timing stock grants with 409A valuations
Companies should award stock-based compensation during 409A valuations to avoid cheap stock issues. This sets the ASC 718 required date and the valuation date as close as possible. This will increase the reliability of estimates because large changes in the valuation are less likely to occur between the grant date and the valuation date.
Independent, retrospective valuation
When a contemporaneous valuation is unavailable, a retrospective valuation is needed to justify any significant differences in valuations. An independent third-party valuation specialist is even more important for retrospective valuations.
Maintain contemporaneous records of business changes impacting valuation
Changes in business and operating environments can significantly impact a company’s value. For example, a technology company may see a significant increase in its value after introducing a successful app to the market. Documentation of these business changes as they occur may reduce SEC scrutiny between pre- and post-IPO equity valuations.
If contemporaneous records were not kept with significant business changes, the company should retrospectively document these business changes as soon as possible. The company should consider supporting documents as close to the grant date as possible in this retrospective documentation. Some examples include board minutes or audit committee minutes.
Valuation of shares of equity for privately-held companies is complex and subjective. ASC 718 requires compensation expense to be based on the value of the compensation awards at grant date. Compensation expense in multiple years, including years after an IPO, can be impacted by a single pre-IPO stock option award. Companies should be frequently and contemporaneously valuing their stock when awarding stock-based compensation. When the underlying pre-IPO share price of stock-based compensations is valued significantly below the IPO share price, cheap stock issues may exist. Firms should address these issues before going public.
The AICPA created a non-authoritative resource for privately-held corporations seeking to appropriately value and disclose stock-based compensation, titled Accounting & Valuation Guide Valuation of Privately-Held-Company Equity Securities Issued as Compensation. This AICPA guide focuses on measuring the fair value of equity securities and the financial reporting of stock-based compensation.
- Division of Corporation Finance, Financial Reporting Manual, August 2017
- Deloitte, A Roadmap to Accounting for Share-based Payment Awards. Third Edition, April 2015
- PWC, Stock-based compensation, A multidisciplinary approach 2013. Second Edition, July 2015
- SEC, Codification of Staff Accounting Bulletins, Topic 14: Share-based Payment. Modified March 14, 2011