How Can an IPO Affect Stock Option Compensation?
Going public can be an exciting time for a company, and while the enthusiasm is understandable, firms that compensate their talent with equity may have additional due diligence items to add to the already-Herculean IPO to-do list.
Equity Compensation may not be top of mind, but it is likely helpful to start thinking about it earlier rather than later. Stock based compensation is a highly regulated practice, and private firms are often not accustomed to the level of scrutiny that will come from regulators, shareholders, proxy advisory firms and the media upon going public. As a finance or equity administration professional, the brunt of this work may fall onto your shoulders. Check out our list of things you may want to keep in mind:
Stricter Valuation Methods
Private companies may have some flexibility in valuing grants for compensation expense purposes. Using valuation models, such as Black-Scholes to value the company’s grants may not have been required, especially in the company’s early days, as determining the price volatility assumption might have been problematic.
Your team may have been able to establish an estimate based on alternative valuations:
- Internal market and private transactions based off historical data;
- Calculated value; or
- Intrinsic value.
Each of these valuation methods may be imprecise. Calculated value relies on an industry appropriate index in place of the price volatility assumption. It takes into account industry and size of the company, which may require a weighted average if a company is categorized in more than one industry.
If your company is in an IPO readiness phase though, it is possible that your team has already switched over to an approved option-pricing model.
Public companies are required to follow an approved option-pricing model, such as Black Scholes. The company’s Management Discussion & Analysis (MD&A) must include all changes in accounting policies upon going public, including your valuation calculation methods.
Whether the company needs to revalue pre-IPO grants is a question for your company’s auditors. If there are no changes to the pre-IPO grants, there may be no need to revalue them. If there are changes to the pre-IPO grants, they may need to be revalued and adjustments made to the life to date stock-based compensation expense recorded. Moving forward as a public company, all new grants will need to be valued using a valid option pricing model.
Sooner Rather than Later
If a company is seen to issue “in-the-money” options as opposed to “at-the-money” options, the company is usually required to record a “cheap stock” charge equal to the difference between the exercise price and the IPO price. A “cheap stock” is one that is issued at an exercise price considerably lower than the IPO price, unless the company can point to a specific event that caused the drastic price change over a short time frame.
In order to avoid suspicions of issuing “cheap stock”, it may be helpful to examine the company’s option pricing model 18 to 24 months prior to going public.
409A Valuations May Help
Obtaining frequent 409A valuations in the period leading up to a company’s IPO may help to avoid “cheap stock” issues. Our 409A team suggests that your 409A appraiser is independent and documents its methodology used to value the grants. In addition, they also suggest that companies get frequent 409A valuations in anticipation of an IPO. For some companies, they suggest getting a new valuation for each grant date and avoiding granting awards when a new valuation is pending.
Addressing Post-IPO Stock Compensation Challenges
Keeping everyone in the loop can help to alleviate potential problems post IPO. The decision as to what kind of equity a company offers may have multiple stakeholders. For instance, HR may be interested in the different types of employee stock compensation plans to use as recruitment and retention tools. In addition, keeping your accounting team informed as to the plans for new equity programs can help them to plan for the future recording of stock-based compensation expense and public financial reporting.
- Employee Stock Purchase Plans (ESPPs) may be a way to encourage broad-based employee ownership. Remember though, Section – 423 qualified ESPP plans have unique taxation and accounting considerations.
- Performance awards may seem like a useful tool in compensating your executives, but they may introduce the need for probability accounting or more complex valuation models, such as the Monte Carlo Simulation.
- The company may have the flexibility to issue cash-settled grants, such as RSUs, which come with the additional complexity of liability accounting.
Attention to ISOs
ISOs have preferred tax treatment, but only $100,000 worth of shares can be exercisable each year. This annual limit is based on the strike price. Portions of ISOs that exceed the $100,000 limit are considered non-qualified stock options and not eligible for the same preferred tax treatment. Companies are required to withhold taxes and report the gain on any exercise of the non-qualified portion of the grant at the time of exercise. This withholding may include your company’s matching FICA and FUTA payments (if applicable). Penalties for not withholding the appropriate taxes can be up to 100% of the amounts that should have been withheld, can include interest and other administrative fees, and, in extreme cases, can involve criminal penalties. Additionally, by not properly reporting the income realized by employees upon exercise, the company won’t be able to claim applicable tax deductions on that income.
A good ISO review can help to catch improperly calculated limits prior to IPO.
There’s going public – and then there’s being public
Public companies are responsible for a variety of disclosures in relation to their equity compensation that private companies are not, including but not limited to:
- Basic as well as Dilutive Earnings per Share (EPS), per ASC Topic 260.
- Additional disclosures required for your Forms 10-Q and 10-K, including the number of exercisable outstanding options, as well as the weighted average exercise price of those options.
- Internally, your finance team may want regular forecast updates on projected stock based comp expense and taxes due from equity transactions, like RSU releases.
Public companies also may need to be prepared for daily transactions to begin to occur once trading windows begin to open. This includes ensuring accurate payroll reporting for taxable compensation resulting from equity transactions and share settlement procedures.