Financial Information – What is “cheap stock”? – (40)

What is “cheap stock”?
Many offerings involve grants of options to officers, directors and employees before the IPO process begins.
The impact of any option grant on the company’s financial statements in the prospectus and in subsequent SEC filings should be discussed with the company’s accountants, underwriters and counsel before any action is taken as these grants raise accounting issues that can result in less attractive financial results. In addition, under IRS regulations, stock options that are not priced at their fair market value as of the date of the grant may subject the option holder to an excise tax on this component of compensation.
“Cheap stock” describes options granted to employees of a pre-IPO company during the 18-24 months prior to the IPO where the exercise price is deemed (in hindsight) to be considerably lower than the fair market value of the shares at grant date. If the SEC determines (during the comment process) that the company has issued cheap stock, the company must incur a compensation expense that will have a negative impact on earnings. The earnings impact may result in a significant one-timecharge at the time of the IPO as well as going-forwardexpenses incurred over the option vesting period. In addition, absent certain limitations on exercisability, an option granted with an exercise price that is less than 100% of the fair market value of the underlying stock on the grant date will subject the option holder to an additional 20% tax pursuant to Code Section 409A.
The dilemma that a private company faces is that it is unable to predict with any certainty the eventual IPO price. A good-faith pre-IPO fair market value analysis can yield different conclusions when compared to a fair

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