The decision to go through an initial public offering (IPO) takes some consideration. On one hand, public company status brings the possibility of new sources of capital, greater liquidity for key investors, and an increase in your company’s profile. On the other hand, it brings a host of new regulations and a new type of scrutiny on your company’s financials.
The U.S. Securities and Exchange Commission (SEC) levies specific rules on public companies to help ensure their company’s shareholders have visibility into certain components of the company’s operations so that the shareholders can make sound investing decisions. If your company is on the path for the IPO, management should keep an eye on the reporting challenges that accompany public company status. There are a number of valuation matters related to the financial and tax reporting that accompany the filings required by the SEC. The following are a few of the biggest valuation matters that could arise during an IPO.
The Role of Valuation in the IPO
The SEC requires all companies that undergo a registered public offering to complete a registration statement known as the Form S-1 before a company’s securities may be offered for sale. The SEC’s Regulation S-X asks for up to three years of audited annual financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP), as well as any related footnote disclosures to be submitted as part of the filing. Depending on when the registration statement is effective, interim financial statements may also be required.
Companies will need to provide support for the basis of their share-based compensation estimates, and report the fair value of certain equity instruments and debt conversion features, acquired intangible assets, goodwill, and contingent assets and liabilities as part of the Form S-1 filing.
The process of determining fair value can be complex because a valuation provider will need to use subjective inputs and other estimates. In some cases, retrospective valuations may be required. Management teams will need to understand how their valuation providers are reaching their conclusions because they will be required to report on those conclusions and underlying assumptions as part of their Form S-1 filing.
Share-Based Compensation Valuation
One of the ways that start-up companies attract and retain key employees is by giving them partial ownership of the company. For financial reporting purposes, companies will need to provide estimates of the value of their share-based compensation. This can be complicated because one of the more traditional methods of determining fair value of underlying equity securities — looking at observed market prices — is not on the table because the shares of the company are not publicly traded.
Valuation providers most often use an income approach, along with other corroborative methods, to determine the fair value of the company’s equity. Income approaches rely on the use of management’s estimates of future cash flow and other subjective inputs, such as selecting the appropriate discount rates for discounting cash flows, to value a company’s total equity and ultimately the underlying equity securities.
Public companies will face even greater pressure to report accurate share-based compensation results because the expenses surrounding share-based compensation could have such a material impact on the company’s financial position. The SEC asks that companies disclose their use of estimates and assumptions in their Management Discussion and Analysis (MD&A) section of their Form 10-K and 10-Q filings. This information is reported in what is called a Critical Accounting Estimate (CAE) disclosure. In the CAE, estimates will need to be explicit about how the estimate of share-based compensation was reached, including how the estimate accounts for variability.
Companies going through an IPO will also be required to include CAEs in their IPO prospectus. SEC Topic 9520 specifically highlights the information that regulators will be looking for in CAEs for share-based compensation in IPOs, including:
- The methods that management used to determine the fair value of the company's shares and the nature of the material assumptions involved. For example, companies using the income approach should disclose that this method involves estimating future cash flows and discounting those cash flows at an appropriate rate.
- The extent to which the estimates are considered highly complex and subjective.
- The estimates will not be necessary to determine the fair value of new awards once the underlying shares begin trading.
It is not uncommon for companies going through an IPO to face intense scrutiny from SEC staff around their CAE disclosures in their filings.
Aside from ensuring that these estimates abide by fair value standards, management must be able to explain changes in share prices from reporting period to period.
Other Valuation Considerations
In addition to share prices being reported at fair value, companies must also be able to provide fair values for instruments linked to the company’s underlying equity. U.S. GAAP asks that companies report the fair value of preferred stock and debt-conversion features for each measurement period. Embedded derivatives, beneficial conversions, and attached warrants, among other financial instruments, may be need to be reclassed and valued.
Management teams may be required to engage a valuation professional to perform retrospective valuations, which can present complications in generating appropriate projected cash flow models, and recalling expectations at each measurement date.
If the company had any previous acquisitions, management should also ensure that all acquired intangible assets, goodwill, and resulting contingent assets and liabilities are also reported at fair value.
Accurate valuation services are not only critical for certain financial reporting requirements, but also for certain tax considerations that are subject to SEC review. Internal Revenue Code Section 409A lays out the rules for the taxation of share-based compensation. If share-based compensation is issued below fair market value, it could lead to significant tax implications for recipients of such compensation. Companies that undertake valuation services for their share-based compensation arrangements before their planned IPO can mitigate this potentially detrimental tax consequence for their shareholders and be prepared for the SEC comments related to these issues that arise during the filing process.
What Management Can Do to Make Valuation Matters Easier During the IPO
Building a relationship with an experienced valuation professional can help management be proactive and well-prepared for SEC scrutiny. An experienced valuation provider will provide the necessary documentation to support the basis for subjective valuation inputs and changes in assumptions from reporting period to period.
Companies that have an IPO in mind should bring in a valuation team early to help them navigate the potential valuation challenges with financial reporting. For more information about valuation matters in the IPO, please contact the author Bianca Cuniglio at email@example.com.
Published on October 22, 2019