13.8 Transition From Nonpublic to Public Entity Status

Question 4 of SAB Topic 14.B discusses the SEC staff’s views on the disclosure requirements for share-based payment awards during an entity’s transition from nonpublic to public entity status (e.g., when filing its initial registration statement with the SEC).

SEC Staff Accounting Bulletins

SAB Topic 14.B, Transition From Nonpublic to Public Entity Status [Excerpt]

Facts: Company A is a nonpublic entity4 that first files a registration statement with the SEC to register its equity securities for sale in a public market on January 2, 20X8. As a nonpublic entity, Company A had been assigning value to its share options5 under the calculated value method prescribed by FASB ASC Topic 718, Compensation — Stock Compensation,6 and had elected to measure its liability awards based on intrinsic value. Company A is considered a public entity on January 2, 20X8 when it makes its initial filing with the SEC in preparation for the sale of its shares in a public market. . . .

Question 4: Upon becoming a public entity, what disclosures should Company A consider in addition to those prescribed by FASB ASC Topic 718?13

Interpretive Response: In the registration statement filed on January 2, 20X8, Company A should clearly describe in MD&A the change in accounting policy that will be required by FASB ASC Topic 718 in subsequent periods and the reasonably likely material future effects.14 In subsequent filings, Company A should provide financial statement disclosure of the effects of the changes in accounting policy. In addition, Company A should consider the requirements of Item 303(b)(3) of Regulation S-K regarding critical accounting estimates in MD&A.

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4 Defined in the FASB ASC Master Glossary.

5 For purposes of this staff accounting bulletin, the phrase “share options” is used to refer to “share options or similar instruments.”

6 FASB ASC paragraph 718-10-30-20 requires a nonpublic entity to use the calculated value method when it is not able to reasonably estimate the fair value of its equity share options and similar instruments because it is not practicable for it to estimate the expected volatility of its share price. FASB ASC paragraph 718-10-55-51 indicates that a nonpublic entity may be able to identify similar public entities for which share or option price information is available and may consider the historical, expected, or implied volatility of those entities’ share prices in estimating expected volatility. The staff would expect an entity that becomes a public entity and had previously measured its share options under the calculated value method to be able to support its previous decision to use calculated value and to provide the disclosures required by FASB ASC subparagraph 718-10-50-2(f)(2)(ii).

13 FASB ASC Section 718-10-50.

14 See Item 303 of Regulation S-K.

SEC Financial Reporting Manual

9520 Share-Based Compensation in IPOs

9520.1 Estimates used to determine share-based compensation are often considered critical by companies going public. In particular, estimating the fair value of the underlying shares can be highly complex and subjective because the shares are not publicly traded. The staff will consider if a company performing these estimates is providing the following critical accounting estimate disclosures in its IPO prospectus:

The methods that management used to determine the fair value of the company’s shares and the nature of the material assumptions involved. For example, companies using the income approach should disclose that this method involves estimating future cash flows and discounting those cash flows at an appropriate rate.
The extent to which the estimates are considered highly complex and subjective.
The estimates will not be necessary to determine the fair value of new awards once the underlying shares begin trading.

Companies may cross-reference to the extent that this, or other material information relevant to share-based compensation, is provided elsewhere in the prospectus.

9520.2 The staff may issue comments asking companies to explain the reasons for valuations that appear unusual (e.g., unusually steep increases in the fair value of the underlying shares leading up to the IPO). These comments are intended to elicit analyses that the staff can review to assist it in confirming the appropriate accounting for the share-based compensation, not for the purpose of requesting changes to disclosure in the MD&A or elsewhere in the prospectus.

9520.3 The staff will also consider other MD&A requirements related to share-based compensation, including known trends or uncertainties including, but not limited to, the expected impact on operating results and taxes.

Typically, a registrant undergoing an IPO of its equity securities identifies share-based compensation as a critical accounting estimate because the lack of a public market for the pre-IPO shares makes the estimation process complex and subjective.

Further, paragraph 7520.1 of the FRM outlines considerations related to the “estimated fair value of [stock that] is substantially below the IPO price” (often referred to as “cheap stock”). Registrants should be able to reconcile the change in the estimated fair value of the underlying equity between the award grant date and the IPO by taking into account, among other things, intervening events and changes in assumptions that support the change in fair value.

The SEC staff had historically asked registrants to expand the disclosures in their critical accounting estimates to add information about the valuation methods and assumptions used for share-based compensation in an IPO. In 2014, however, it updated Section 9520 of the FRM to indicate that registrants should significantly reduce, in the critical accounting estimates section of MD&A, their disclosures about share-based compensation and the valuation of pre-IPO common stock. Nevertheless, paragraph 9520.2 of the FRM notes that the SEC staff may continue to request that companies “explain the reasons for valuations that appear unusual (e.g., unusually steep increases in the fair value of the underlying shares leading up to the IPO).” Such requests are meant to ensure that a registrant’s analysis and assessment support its accounting for share-based compensation; they do not necessarily indicate that the registrant’s disclosures need to be enhanced.

At the Practising Law Institute’s “SEC Speaks in 2014” Conference, the SEC staff discussed the types of detailed disclosures it had observed in IPO registration statements that had prompted the updates to Section 9520 of the FRM. The staff noted that registrants have historically included:

A table of equity instruments issued during the past 12 months.
A description of the methods used to value the registrant’s pre-IPO common stock (i.e., income approach or market approach).
Detailed disclosures about certain select assumptions used in the valuation.
Discussion of changes in the fair value of the company’s pre-IPO common stock, which included each grant leading up to the IPO and resulted in repetitive disclosures.

The staff indicated that despite the volume of share-based compensation information included in IPO filings, disclosures of such information were typically incomplete because registrants did not discuss all assumptions related to their common stock valuations. Further, disclosures about registrants’ pre-IPO common stock valuations were not relevant after an IPO and were generally removed from their periodic filings after the IPO. The SEC staff expressed the view that in addition to reducing the volume of information, streamlined share-based compensation disclosures also make reporting more meaningful. The staff also indicated that by eliminating unnecessary information, registrants could reduce “down to one paragraph” many of their prior disclosures.

At the conference, the SEC staff also provided insights into how registrants would be expected to apply the guidance in paragraph 9520.1 of the FRM (and thereby reduce the share-based compensation disclosures in their IPO registration statements):

The staff does not expect much detail about the valuation method registrants used to determine the fair value of their pre-IPO shares. A registrant need only state that it used the income approach, the market approach, or a combination of both.
Further, while registrants are expected to discuss the nature of the material assumptions they used, they would not be required to quantify such assumptions. For example, if a registrant used an income approach involving a discounted cash flow method, it would only need to provide a statement that a discounted cash flow method was used and involved cash flow projections that were discounted at an appropriate rate. No additional details would be needed.
Registrants would have to include a statement indicating that the estimates in their share-based compensation valuations are highly complex and subjective but would not need to provide additional details about the estimates. Registrants would also need to include a statement disclosing that such valuations and estimates will no longer be necessary once the entity goes public because it will then rely on the market price to determine the fair value of its common stock.

The staff emphasized that its ultimate concern is whether registrants correctly accounted for pre-IPO share-based compensation. Accordingly, the staff will continue to ask them for supplemental information to support their valuations and accounting conclusions — especially when the fair value of a company’s pre-IPO common stock is significantly less than the expected IPO price.1 See Section 4.12.1 for additional considerations related to cheap stock.

Footnotes

At the conference, the SEC staff noted that valuations that appear to be unusual may be attributable to the peer companies selected when a market approach is used. Specifically, the staff indicated that there are often inconsistencies between the peer companies used by registrants and those used by the underwriters, which result in differences in the valuations. Accordingly, the staff encouraged registrants to talk to the underwriters “early and often” to avoid such inconsistencies.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.