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March 1989

The mine field of cheap stock. (includes related article on cheap stock)

by Wegkamp, Paul L., Jr.

    Abstract- Case studies of companies which have attempted to make a first public offering are discussed with particular focus on how to solve the the problem that many new enterprises face: the difficulty of requiring both talented people and money to get started. Current Financial Accounting Standards Board rulings are also included to illustrate aspects of this problem.

In recent years, a serious problem has emerged in the area of stock compensation. Many initial public offerings filed with the SEC, where the company has recently issued stock rights to its employees, have included manipulation of net income and earnings per share by abusing the manner in which the companies have accounted for stock or stock rights issued shortly before they went public. Because these stocks and related rights are issued at prices substantially below the initial public offering price, they are referred to by the SEC staff as "cheap stock."

Cheap Stock Predicament

The failure of a company's counsel and its independent auditors to address the problem of cheap stock before a company issues shares to its employees in contemplation of going public can at best be an embarrassment for the auditors, and at worst, an economic disaster for the company.

In situations where a company has not considered the cheap stock problem, it will find itself, its outside counsel, and its independent auditors in the Chief Accountant's Office, Division of Corporation Finance, at the SEC, defending their accounting treatment. A decision that the company should have treated its issue of stock options as cheap stock can change the company's reported earnings from profitable to unprofitable, perhaps resulting in a significant decrease in the offering price of the stock in its initial public offering. Often the company will also find that it will have to incur additional expenses to recirculate its prospectus because the financial statements in the initial prospectus were unacceptable. The SEC may rule that the facts of the situation do not warrant the recognition of employee compensation, but that the EPS figures are meaningless without the inclusion of the cheap stock retroactively in the EPS calculations for all periods presented. (See the sidebar on Staff Accounting Bulletin Topic 4-D.) In other words, at the very least the SEC will require the company to restate all EPS figures for the cheap stock, and, in the worst-case scenario, will make the company record employee compensation.

Cheap Stock Impact

Additional Compensation

This problem can be demonstrated by examining the experience of a software company in its recent filing of a Form S-1 with the SEC. A filing was made to register 500,000 shares of common stock at an estimated offering price of $11 per share. The prospectus disclosed that the company had issued a substantial number of stock options, just prior to its filing with the Commission, at exercise prices not less than the fair market value determined by the company's board of directors. The SEC staff informed the company that sufficient evidence existed that the valuations of the options were too low. A significant part of this evidence was that some of the options had been granted within two weeks of the filing of the initial public offering at $.50 per share, which was less than 5% of the estimated offering price. It was also noted that the company had been profitable for the last two and a half years, and that two years prior to the filing had issued convertible preferred stock at an equivalent common stock price of $3 per share.

In view of this information, and in order to estimate the amount of additional compensation to be recorded, the SEC staff issued the following comment to the company:

"...please advise as to the dates, number of shares, and

exercise prices for the options granted during the indicated

period. In reference to these options and other

sales to employees..., it appears that a measurable

element of compensation is involved and should be


The company replied that they believed that the preferences of the preferred stock, such as the right to receive dividends before any dividends are paid to common shareholders, supported the difference in price between the preferred shares and the common stock option exercise price.

Notwithstanding the company's arguments, the staff issued the following reply:

"...it is the staff's position that compensation expense

should be recorded for the difference between the common

stock and option prices and at least 50% of the

initial offering price of all stock and options issued within

one month of the initial filing date of the registration

statement, and the difference for at least 25% of the

public offering price for all items issued prior to that

period.... In addition, the transactions should be discussed

in a subsequent events footnote indicating the

compensation involved."

In response, the company indicated that it would comply with the staff's comment, and agreed to book another $380,000 in compensation expense over the three-year vesting period of the options.

The effect on operating results over the three-year period was immaterial; however, as a result of the delay in solving the issue, the company went effective when the market was turning "bearish." In order that the underwriters could be assured of selling all of the shares being offered, the offering price was reduced to $9 per share, resulting in a loss of $1 million in equity funds for the company.

Earnings Per Share Restatement

An example of a company that was significantly affected by the SEC's ruling that cheap stock should be included retroactively in earnings per share calculations was a savings and loan corporation that recently filed a Form S-1 with the SEC to register 5,000,000 shares of common stock at an offering price of $15 per share.

Shortly before going public, the company issued stock options to company officers for 8,806,000 company shares at prices substantially below the initial public-offering price. Upon review of the filing, the SEC staff instructed the company to treat all stock options as outstanding for purposes of computing earnings per share, pursuant to Staff Accounting Bulletin Topic 4-D.

The company's earnings per share figure was changed from the preliminary figure of $2.73 per share to only $.70 a share. The resulting impact on the initial public-offering price, along with other mitigating factors, was a decrease of $6 per share, which in turn resulted in a shortfall of $30 million in equity funds! A summary of this example, along with summaries of the experience of several other companies that have had their earnings per share figures affected by cheap stock, is presented in Exhibit I.

The Juggling Act

How do the company and its independent auditors find themselves in these predicaments? Often it is the result of a juggling act played by the company once it decides to go public. In an effort to attract, reward, and retain key employees, the developing company promises a large future payoff in return for the employees' services at salaries less than the industry norm. The large payoff is almost always in the form of stock options that can be exercised in contemplation of going public. The dilemma faced by the company is how to avoid accruing large compensation costs when the company is trying to present encouraging operating results to the public. This manipulation of a company's operating results in the compensation area, although certainly improper, nevertheless can be attempted under present-day promulgated GAAP.

The success of some companies in resolving the dilemma is in direct correlation with their understanding of the complexities surrounding stock compensation, their subsequent-structuring of employee stock option plans, and the criteria used by the SEC in reviewing prospectuses that contain employee stock option plans.

Root of the Problem

The root of the problem revolves around the proper date to measure compensation cost and the manner of measurement. Paragraph 10 of APBO No. 25 states that:

Compensation for services that a corporation receives

as consideration for stock issued through employee stock

option, purchase, and award plans should be measured...at

the measurement date...The measurement

date for determining compensation cost in stock option,

purchase, and award plans is the first date on which are

known both (1) the number of shares that an individual

employee is entitled to receive and (2) the option or

purchase price, if any." The paragraph concludes that the measurement date for most plans is the grant date, while the measurement date would be later for those plans that include variable terms.

It is in this area that the managers of a private company contemplating going public can be tempted to manipulate income because they decide the value that should be assigned to the employee services received at the grant date. Indeed, promulgated GAAP allows the company to assign no value to the employee services received. Paragraph 10 of APBO No. 25 states that compensation

"...should be measured by the quoted market price of

the stock at the measurement date...If a quoted

market price is unavailable, the best estimate of the

market value of the stock should be used to measure

compensation." Because a private company will not have a quoted market price, the company's board of directors will usually determine the "fair value" of the shares of stock issued. The board should consider a number of factors in determining the stock's fair values, such as share prices in private placements, recent operating results, and restriction on the stock options. Once the board has made its determinations, the stock option plan most often calls for a certain amount of stock to be issued on the grant date at an exercise price equal to the fair value as determined by the board. Therefore, no compensation expense is accrued because the employees will be required to pay the "fair market price." Because the "fair market price" as determined by the board of directors is usually much less than the initial public-offering price, the employees can increase their investment by many times over what they paid within a few months' time by exercising their options!

What is Being Done

Given the above scenario, one might ask is anybody doing anything about the cheap stock issue other than the SEC. The answer is yes: though, it has not been widely publicized. The Emerging Issues Task Force, whose findings are supported by the staff of the SEC, at its April 21, 1988 meeting, reached a consensus on Issue No. 88-6, Book Value Stock Plans in an Initial Public Offering. The task force concluded that a book value stock purchase plan that becomes a market value plan upon a company's going public should be accounted for as a stock appreciation right under FASB Interpretation No. 28. In other words, compensation expense should be recognized for the difference between market value and book value when the company turns public, which is in accordance with the practice the SEC has been requiring for such arrangements. FASB is also currently working towards an exposure draft addressing the stock-compensation issue. The exposure draft is tentatively set to be released at the end of 1988, to overcome the inadequacies of APBO No. 25 in dealing with new types of compensation plans and the effects of the volatility of stock prices on the recognition of compensation.

Vesting-Date Accounting--The Answer?

At the time of this writing, the author understands that FASB had tentatively concluded that some of APBO No. 25's inadequacies could be overcome by changing the measurement date for recording compensation cost from the grant date to the vesting date for those stock-award plans that are fixed.

Grant Date Versus Vesting Date

The vesting date is the date a stock option or right becomes exercisable by the employee, usually after completion of a stipulated service period. Under the present grant-date method, compensation to be recorded is often determined long before the vesting date.

To illustrate the difference between vesting-date accounting and grant-date accounting, consider the award of a stock option, at July 1, 19x8 (grant date), with an exercise price of $15 per share when the market price is also $15 per share. Assume that the option is subsequently exercised at the end of the required service period July 1, 19x9 (vesting date), when the market price is $20 per share. Under present grant-date accounting, compensation cost would be zero because the market price and exercise price were the same at date of grant. However, under vesting-date accounting the compensation cost is $5 per share, the difference between the market price and the exercise price at the vesting date.

Impact on Cheap Stock

Vesting-date accounting is at best a partial solution to the cheap- stock issue. For those stock compensation plans where the vesting date falls after a company's public offering, the appropriate fair value of the stock will be used in determining the element of compensation cost incurred, as demonstrated in the previous example. However, by setting the vesting date before its public offering, the company can avoid having to use the market value as determined by the per-share price received in the offering or the quoted market price after the offering. In other words, vesting-date accounting will solve the issue of cheap stock as far as the appropriate compensation amount to be recorded--but for only those plans where the vesting date occurs after the public offering.

Obviously, vesting-date accounting will have no impact on the issue of cheap stock being included retroactively in EPS calculations. Apparently, the SEC's ruling that past EPS results are meaningless when large blocks of company shares are issued at prices substantially below fair market value, is considered to be beyond the scope of the proposed exposure draft.

Thus, FASB's recommendation of vesting-date accounting will do little to resolve the cheap stock issue. It is an issue that FASB needs to address directly. Only then will a company's ability to manipulate net income and/or EPS results in the stock compensation area be eliminated.

What You Should Do

In the interim, what should a company do when contemplating going public and it wants to issue stock to its employees? First, the company should recognize that compensation will have to be booked retroactively if the SEC staff determines that a plan is compensatory and the company has not accounted for it as such. The staff reviews all types of stock- award plans based on their own merits, and they follow GAAP in determining whether compensation should have been recorded. However, all plans that result in stock being issued to employees at prices substantially below the initial public-offering price shortly before the company goes public are examined closely. If a company anticipates cheap stock problems, it would be prudent to consult with the Chief Accountant's Office of the Division of Corporation Finance to obtain advice on the proper treatment. It would also be in the company's best interests to obtain the services of an investment banker to obtain an independent appraisal of the fair market value of the company's stock at the grant date.

By following these procedures, a company can be assured that its initial filing with the SEC will not be unnecessarily delayed due to a stock-compensation issue. The user of the company's financials can also be assured that the effect of the stock-compensation arrangement will be reflected properly in the financial statements.

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