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October 29, 2013

The 5 Best Practices of Cheap Stock

Posted by Armanino Financial Advisory Team

From a tax perspective, cheap stock has major individual tax consequences—back-dating and granting equity instruments below fair market value (FMV) can create cheap stock scenarios. In some cases, this type of compensation can trigger a 20% tax penalties on top of ordinary income rates (to learn more about this issue, watch our recorded webinar on 409A Valuations – Hot Button Issues with Auditors), in other cases the company may cover this penalty for the goodwill of its employees.

The other side of the coin for cheap stock is a much different story.  When referring to cheap stock from an accounting perspective to the corporation, we typically move into ASC 718 Accounting for stock-based compensation. Here, cheap stock carries different weight, as it causes greater non-cash expense than would otherwise be recognized.

How does cheap stock arise?

For private companies, cheap stock mostly occurs in the few years prior to IPO due to an almost unavoidable valuation and grant timing difference.  In fact, just this month, I’ve seen two examples from the SEC and auditors confirming that companies on the IPO track should be taking cheap stock expensing.

5 Best Practices

If you’re headed toward an IPO, or your company is planning a liquidity event, here are some best practices to consider:

  1. Avoid granting options within the month right before a valuation
  2. Grant options as close to the valuation date as possible
  3. Ensure the valuation is reviewed by your auditors before the board approves it
  4. Do a cheap stock analysis early on in the IPO planning process
  5. Address cheap stock before review, incorporate values and adjust your stock compensation expense

More and more companies are increasing their stock-based compensation expense, so this is vital information to keep in mind.

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