Preparing for an IPO is a significant undertaking for all private companies, but it can be especially challenging for those that offer equity compensation to employees.

Equity compensation is an essential tool for recruiting and retaining talent—especially for companies that want to build a strong management team before going public. However, while equity compensation is a powerful incentive that makes more cash available for other business needs, it creates additional financial reporting requirements.

Fully understanding these requirements and preparing for a valuation well in advance can greatly ease the IPO process. Get an overview of key requirements and steps your company can take to receive a valuation, remain compliant, and successfully enter the public market with the following insights.

IPO Readiness Requirements

Companies that offer equity compensation must do the following before an IPO:

• Ensure regular valuations of company stock have been performed, through valid modeling by valuation specialists, so that any outstanding instruments that must be measured at fair value as set out in the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 718, due to the IPO or otherwise have captured the typical increase in value leading up to an IPO.
• Report for tax purposes the fair market value of stock issued for compensation, as specified in Internal Revenue Code (IRC) Section 409A.

Fulfilling these requirements can be complex, so it’s useful to know how the SEC will review your company’s stock-based compensation costs as well as how to obtain an estimate of your company’s value.

There are four key areas companies should understand before receiving a valuation:

• SEC authoritative guidance relating to equity compensation
• Common 409A valuation approaches and inputs
• The evolution of logical stock-value progression
• Management’s discussion and analysis disclosures (MD&A)

SEC Authoritative Guidance

As part of its review of filings for an IPO, the SEC will analyze a company’s awards and valuations from a 12 to 18-month period prior to the IPO date. In certain circumstances, such as large stock option grants before this time frame and changes in calculation technique or model chosen, the lookback period can be two or three years.

During this review, the SEC will typically focus on what’s known as cheap stock, which are stock-based awards given as compensation, that are heavily in-the-money. It then addresses 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, which was created by Staff Accounting Bulletin (SAB) No. 107 and updated by SAB No. 110. The interpretations of this guidance are applicable to companies seeking to become public.

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).

It’s important to fully understand how the SEC will scrutinize your company’s compensation, valuations, and compliance because issues arising in these areas can lead to subsequent accounting changes and financial statement corrections that will delay the IPO process and possibly have negative tax repercussions for the company and option holders.

409A Valuation Approaches and Inputs

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 ways to approach a 409A valuation, and each can help you estimate the value of your private company’s equity.

Valuation Approaches

Income Approach

This method involves discounting the future expected cash flows of the company that are expected by the equity holders. It uses a discount rate that incorporates the risk of realizing those cash flows.

Market Approach

The market approach encompasses several different pricing methods. This method uses market-derived pricing multiples taken from a group of comparable publicly traded companies or recent transactions in private companies.

These pricing multiples might include:

• Earnings per share (EPS)
• 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 is equal to 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.

Asset Approach

The asset 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.

Equity Allocation

Once an equity value has been established, this value will be allocated among the different stockholders. In the case of a complex capital structure, which may involve preferred stock with differing levels of seniority, an allocation method will be required.

These methods include:

• 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.

Discount for Lack of Marketability

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 is often necessary because private-company equity owners typically don’t enjoy the liquidity of a freely traded public security. Typically, 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.

409A Valuation Approach Adjustments

As an IPO becomes more likely, the 409A valuation approach should evolve. If a company has 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 should begin transitioning to the hybrid method that incorporates an IPO scenario.

Regardless of which method is used, an increasing amount of weight should be placed on the IPO scenario as the transaction draws closer.

Additional Value Indicators

Other value indicators, such as private placements or other transactions in the company’s securities, often come into play as a company nears an IPO. Any transactions in the company’s equity securities should be evaluated based on considerations set forth in the AICPA Accounting and Valuation Guide and weighted appropriately.

The weighting applied to these transactions is subjective, and all the factors considered in arriving at the weighting should be detailed in the valuation report.

Investment-Banker Valuations

Early in the IPO process, a company may engage investment bankers to complete the IPO. The investment bankers will provide a presentation in which they estimate the value of the company on the IPO date.

Guideline Companies

The professional performing the 409A valuation should understand which comparable companies and valuation measures the investment bankers select in their valuation. Entities selected as guideline companies in the 409A valuation should be similar to those used by the investment bankers.

If the valuation professional selects different entities as guideline companies, they should be able to articulate why different entities were selected. The value implied by the investment banker shouldn’t necessarily be used in the 409A valuation, but differences in the two values should be explainable.

Key Differences

One of the significant differences between the investment banker valuation and the 409A valuation will likely be the DLOM. The investment banker valuation won’t include a DLOM. The 409A valuation, however, will include a DLOM because the company’s equity securities aren’t yet marketable.

Before the IPO is contemplated, the DLOM can be significant. As a company nears the IPO date, there should be a steady decline in the DLOM.

The DLOM is typically determined using quantitative models that determine the cost of a hypothetical protective put option that spans the time until the securities become marketable.

MD&A Relating to Valuations

Valuation reports that include full discussions of valuation techniques, significant factors, and assumptions can be very beneficial when a company is preparing the MD&A disclosures required in SEC filing documents. They can be an extreme help to management in their preparation of an effective discussion about the appropriateness and accuracy of fair values assigned to stock-based grants as well as paint a cohesive picture of company developments that have led to changes in value between their grant dates and the estimated IPO price.

These components aren’t always present in hastily performed or abbreviated valuation reports.

When preparing MD&A disclosures, the SEC’s list of generally asked questions about compliance and disclosure requirements can help companies resolve related questions.

Next Steps

After gaining a comprehensive understanding of potential valuation approaches, it’s time to begin the process.

If your company is considering an IPO, it’s important to select a valuation professional with significant experience valuing pre-IPO companies for 409A including valuing those companies that have undergone the IPO process. In many instances, your financial statement auditor can provide a referral(s). 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 the following steps:

• Schedule a meeting with the valuation professional and your auditor, including their valuation experts.
• 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. You will want to engage a valuation expert who will be able to work with you through the IPO process. This is not the time to save a few dollars on automated 409A.
• Request a draft of the valuation so your auditors can review it and provide questions or feedback before the valuation is finalized.

Changes in Value

Over the two-to-three years leading up to an IPO, it’s comforting to see a steady increase in common stock value to the eventual IPO price, though it isn’t necessary as there can be complications in the process.

Any changes in value must be explainable based on the following factors:

• Changes in the economy
• Industry trends
• Company finances and operations
• Market trends

Rapid increases in common stock value just before the IPO and significant gaps in value from the eventual IPO price will likely result in more SEC scrutiny. Consider having multiple valuations a year— quarterly or semiannually—as you get closer to IPO. Your valuation specialist and auditors can set an appropriate timeline based on how many options you plan to grant in the last 12-18 months before IPO.

Your company’s valuation should detail factors considered during the valuation and tell a story about how the value was derived. This detail is especially important because any scrutiny is likely to take place after the valuation date when the IPO is already in process.

We’re Here to Help

To learn more about the IPO process or to get started with your company’s 409A valuation, contact your firm professional.

Additional Resources

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• Valuation Services