Due to the fallout from the Lehman Brothers bankruptcy and the resulting severe decline in public equity markets, the period from the fourth quarter of 2008 through the first quarter of 2009 was one of the single worst periods ever for initial public offerings (“IPOs”) of financial sponsor-backed companies. The gains in stock prices during the remainder of 2009 and into 2010 have helped restore the confidence of financial sponsors in the public market as an exit option, even if there is some skepticism amongst the large institutional investors (pension funds, endowments, and insurers) about the quality of the firms being targeted for IPOs and the reasons for bringing them public.
In the past, an IPO might have been seen primarily as a mechanism for a return of investor capital in a highly successful company. In today’s environment, the proceeds are just as likely, if not more so, to be used primarily to strengthen the company’s balance sheet with little if any resulting distribution of proceeds. While a significant number of this year’s scheduled IPOs have been postponed or shelved amid stock market volatility, the pace of financial sponsor-backed IPOs is expected to continue to increase as we move forward.
The IPO process can mean significant changes in the accounting procedures for the filing company. The independent auditors of the company are required to be registered with the Public Company Accounting Oversight Board (PCAOB). As a result, the company may need to change its auditors and get new audited financials in connection with its IPO. A key step in the IPO process is the preparation of the Securities and Exchange Commission (“SEC”) Form S-1 (the “S-1”), also known as the registration statement. Preparation and review of the S-1 is a multi-faceted effort that must be coordinated amongst the filing company’s own executives, attorneys, auditors, and underwriters and the underwriter’s counsel. The S-1 contains the prospectus, and is both a disclosure statement and a promotional document that must conform to SEC guidelines as to form and content.
The S-1 will need to contain audited and unaudited consolidated financial statements of the company for the prior three years (and interim quarterly unaudited financial statements for the period since the end of the last fiscal year) and selected annual consolidated financial data for the prior five years. In the accounting due diligence process, a number of valuation-related matters will certainly draw scrutiny and, if not properly addressed, can become a problem that will alter or delay the IPO process.
In any review of an S-1, the filer can anticipate that the SEC staff will scrutinize whether the company should have recorded compensation expense with respect to compensatory stock or option grants made in the 18 to 24 months leading up to the anticipated offering date. This issue has become more of a hot-button issue for the SEC in recent years, particularly when the security value estimates used at the time of the grants differ materially from the range of anticipated IPO prices being targeted by the underwriter. The SEC requires a prospective issuer to record compensation expense for any option granted to employees with an exercise price, or any stock sold with a purchase price, below the Fair Market Value of the underlying stock on the grant date. Addressing any such potential issues up front can minimize the impact resulting from an unforeseen “cheap stock” comment by the SEC’s staff, which if not addressed adequately can result in a restatement of the financial statements to record additional compensation expense. It should also be recognized that the SEC’s perspective on Fair Value for financial reporting purposes or Fair Market Value for tax purposes doesn’t necessarily neatly correspond with the IRS’s perspective on Fair Market Value.
While they are likely to closely scrutinize such Fair Value or Fair Market Value estimates, the SEC does recognize that that there are a number of factors that may contribute to a difference between the value of an enterprise’s privately issued equity securities prior to an IPO and the ultimate IPO price. Among these factors are 1) whether or not the enterprise achieved business milestones during the periods preceding the IPO, such as regulatory approvals, intellectual property developments, resolution of litigation, acquisition of significant new customers, etc. (which may change the amount, relative timing, and likelihood of expected future net cash flows); and 2) broader economic factors. In addition, the IPO generally reduces the newly public company’s cost of capital by providing it access to more liquid and efficient capital markets.
Every company looking to go public that has made compensatory stock or option grants should be prepared to justify its determination of the common stock’s value as of each grant date. A contemporaneous valuation of the common stock’s value at or near the time of certain option grants provides credible evidence to the SEC that the grants in question were recorded at an appropriate value. However, the SEC has been known to reject independent valuations that appear made-to-order or that have other deficiencies. Thus, a truly independent analysis by a reputable valuation firm will serve the filer well in any IPO process. In addition, in any subsequent challenge by the SEC, the filer’s position will be strengthened if management and/or their valuation advisor have consistently followed the same valuation approach. It is not uncommon for the SEC’s comment letter to articulate numerous and detailed objections to the valuation methodologies employed and the key assumptions incorporated in the valuation analysis.
While there is always scrutiny of the application of the standard enterprise valuation methodologies (Income Approach, Market Approach, and Cost Approach), another issue related to measurement of the value of these stock and option grants that has led to numerous SEC comments is the methodology employed in apportioning overall enterprise value to the various capital classes in arriving at the common equity value. A company’s stage of development and the makeup of its capital structure can pose often overlooked valuation challenges, particularly when measuring equity value for purposes of financial or income tax reporting. If the subject company’s capital structure is highly leveraged or consists of classes of securities more complex than plain-vanilla debt and equity (e.g., convertible preferred stock), the valuation professional must apportion enterprise value to each security class based on the rights and preferences thereof.
Common equity reflects a residual interest in the company’s value after considering senior securities such as debt. Typically, common equity value is determined by valuing the business as a whole, or the enterprise value, and then subtracting the values of securities senior to common equity in the capital structure. This is known as the current value method. The inherent assumption with this methodology is that the company is sold as of the valuation date and the proceeds are distributed in accordance with investor’s liquidation rights. This might be applicable in certain circumstances, but most companies operate as going concerns without an imminent liquidation event, particularly those that are viewed as IPO candidates. In fact, the SEC has commented publicly that, in its view, it is very unlikely that the use of a current value allocation method would be appropriate in any IPO reporting period.1
There are two other generally accepted methods of allocating value to the various components of the capital structure. Described in the American Institute of Certified Public Accountants (“AICPA”) practice aid, Valuation of Privately-Held Company Securities as Compensation, these approaches are based on two key premises. First, the value of each class of securities should result from the security holder’s expectations about future economic events and the amounts, timing, and uncertainty of future cash flows. Second, at least some nominal value must be assigned to the common shares unless the enterprise is being liquidated and no cash is being distributed to the common shareholders (i.e., there exits option value). These methods are known as the Probability-Weighted Expected Return Method (“PWERM”) and the Option Pricing Method (“OPM”).
The PWERM estimates common equity value based upon an analysis of various future outcomes, such as an IPO, merger or sale, dissolution, or continued operation as a private viable going concern. The allocated value is based upon the probability-weighted present values of expected future investment returns, considering each of the possible outcomes available to the enterprise, as well as the rights of each security class.
The OPM treats equity as a call option on the enterprise’s value. The characteristics of each class of capital, including any liquidation preferences, redemption rights, or conversion rights, determine the class of capital’s claim on the overall enterprise value. The value of the equity is based on the optionality over and above the value of the claims of securities senior in the capital structure.
It is important to note that no single allocation method is superior in all respects and in all circumstances. Each method has its own merits and problems, and there are tradeoffs in selecting one method over the others. However, when applying one (or more) of the valuation allocation techniques, it is important to note that the SEC has openly questioned the appropriateness of averaging allocation techniques that yield materially different results. In a statement, the SEC noted:
“In some case the underlying conceptual differences between certain allocation methods would appear to render the results of averaging somewhat meaningless. For example – the PWERM is forward looking and the current value method is not. Averaging a forward looking allocation method that considers the value inherent in a going concern with an allocation method that does not is like trying to average apples and oranges. The result isn’t meaningful.2”
In addition to anticipating scrutiny related to enterprise valuation and apportionment of value to various capital classes when estimating the value of stock or option grants, one must also give careful consideration to the fact that the allocation technique employed likely includes assumptions related to a prospective liquidity event in the future. The timing of this event should be carefully considered in the determination and application of appropriate discounts for lack of control or marketability.
While the lack of control or minority interest discount has generally been recognized and relied upon historically in valuations of closely held businesses for estate and gift tax planning purposes, its use is of particular concern to SEC staff.
“In evaluating this assertion, we focused on whether management could demonstrate that the cash flows used in the income approach included disproportionate returns to certain shareholders. That is, could management support with objective and reliable information that the controlling shareholders received greater returns than the minority shareholders not through their rights as stockholders, but through their participation, perhaps as employees, in the ongoing operations of the business…The bottom line here is that if management cannot support with objective and reliable information that there is a disproportionate return to certain shareholders, either through the enterprise value cash flows or the equity rights, we do not believe that a lack of control discount is appropriate.3”
The SEC is also very focused on selection and justification of marketability discounts in the estimation of the value of compensatory awards. Too often there has been tendency in valuation analyses to blindly rely upon the averages seen in the variety of studies performed over the years to quantify the magnitude of marketability discounts. To fully satisfy the expectations of the audit and regulatory community, one must draw distinctions between the set of circumstances of the subject company and that of the companies in the referenced studies, with the primary differentiators being the duration of the marketability restrictions and the perceived volatility of the underlying stock.
Even in the rare circumstance where there have been no compensatory stock or option grants in the months leading up to an IPO, attention must be paid to other valuation estimates that have been made, or should have been made, in the years prior to an IPO. The process of assembling S-1 ready financial statements, whether involving a new audit or not, can result in further scrutiny of previous valuation estimates made for accounting purposes, particularly as it relates to purchase price allocations made related to a series of acquisitions leading up to the IPO.
The prospective filer will often find that the litmus test for materiality changes in the review of previous valuation estimates as they approach an IPO. Purchase price allocation valuation methodologies and assumptions that may have been acceptable on individual smaller transactions in a prior audit environment may appear less appropriate in hindsight when looked at with the valuation estimates made for a series of acquisitions. The prospective filer may find that reconsideration is necessary for previous treatment of a variety of items, including, among others, deferred revenue asset or liability recognition, inventory valuation, intangible asset recognition and amortization, and goodwill and indefinite live asset impairment recognition and testing. This additional scrutiny can be both disruptive from a timing perspective and expensive at a late stage in the IPO process.
In order to facilitate as smooth a due diligence process as possible, one area that a prospective filer can control is the timing and quality of work done in making valuation estimates necessary for accounting purposes. Doing this work contemporaneously and doing it right the first time will save time, aggravation, and professional fees (of the audit, legal, and valuation variety) in the long run.
1 Todd E. Hardiman, “Speech by SEC Staff: 2004 Thirty-Second AICPA National Conference on Current SEC and PCAOB Developments,” U.S. Securities and Exchange Commission, 6 December 2005, http://www.sec.gov/news/speech/spch120604teh.htm.
2 Ibid.
3 Ibid.
