In recent years the SEC has been challenging the exercise prices of stock options granted while a company is private, claiming that the exercise prices were
below the market value of the stock at the time of grant. The resulting difference between the exercise price and the market value must be accounted for as a compensation expense and amortized over the vesting periods of the options. Since stock options are one of the major components of compensation for manystart-up companies, this compensation expense can be signiﬁcant, thus having a material effect on reported ﬁnancial results. Whether this will negatively impact the IPO valuation is dependent on the current market view of this expense.
Companies preparing for an IPO need to carefully review their option pricing history. Where option prices are signiﬁcantly less than the price of any convertible preferred stock sold near the dates of option grants, there will be close scrutiny by the SEC, and the closer the grant dates are to the IPO, the more intense
Beneﬁcial conversion features of preferred stock and debt
Similar to the cheap stock issues, the SEC has recently begun focusing on the conversion price embedded in convertible preferred stock and debt securities issued within one year of an IPO. Such conversion prices are compared with the IPO price by the SEC to determine whether a “beneﬁcial conversion feature” exists (i.e., the conversion price is below the fair value of the common stock
on the commitment date). If it is determined to be recorded as a beneﬁcial conversion feature, the “in the money” portion would be a reduction to net income available to common shareholders and therefore reduce earnings per share. In the case of convertible debt securities, the “in the money” amount would be considered to be additional interest expense.
In recent years the area of revenue recognition has received a great amount of attention from the standard-setting bodies as well as the SEC. This has been due in large part to the signiﬁcant revenue multiples many early-stage technology companies receive in the markets. In addition, many new and complex transactions are being created by the technology industry and the creative methods by which they transact businesses. Some of the areas that can be particularly complicated to deal with are: