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Avoid an IPO false-start by paying close attention to valuation requirements

By: Leon Li

Valuation Requirements for an IPO Filing

Estimated reading time: 2 minutes

Planning for an initial public offering is much like preparing for a marathon—your company must be ready to go the distance. Preparations for an IPO should begin at least 24-months before filing. One of the first steps should be to enlist the help experienced IPO professionals, including a valuation expert.

Valuations are a requirement throughout the IPO process, with the pre-filing stage serving as the starting line. Many other mile markers will call for further valuation analyses, some of which will necessitate retrospective scrutiny.

Carefully managing valuation considerations will minimize the time, effort, and costs of the IPO filing process. In this article, we address some of the most common valuation matters that must be addressed when your company is in training for its IPO marathon.

Share-Based Compensation

An entity preparing for an IPO may have a share-based compensation strategy to retain and attract employees. The awards often come in the form of stock options, appreciation rights, restricted stock, or an employee stock purchase plan.

Cheap stock refers to equity instruments including stock, options, and warrants typically granted 12- to 24-months before the IPO for a price (or with an exercise price) less than the expected IPO price. This usually results in the recognition of additional compensation expenses and potential immediate taxes due to company employees. Therefore, it is essential companies use an abundance of caution to fair value the underlying stock.

In addition to a typical business enterprise valuation analysis, careful consideration is necessary for the various methodologies of allocating enterprise value to common shares and weighting these methods. The valuation method and weighting selection requires comprehensive consideration and review of key pricing information including the timeline of equity financing activities, material secondary market transactions, and expected IPO price range.

Some awards have complex features that may need to be evaluated in the IPO preparation process:

  1. Repurchase features, often in the form of call or put rights,
  2. Co-existence of IPO vesting condition and market condition, and
  3. Certain modifications that a pre-IPO entity made to its existing awards.
Valuations Required for IPO Filing

Beneficial Conversion Feature

Like cheap stock, another area of focus is the conversion price embedded in the convertible preferred and debt instruments issued within one year of an IPO.

When companies issue convertible securities within a short period before filing the initial registration statement at an (exercise) price below the expected IPO price, it presumes a beneficial conversion feature (BCF). To overcome this, companies need to provide sufficient and objective evidence to support their assertion. The BCF, or “in the money” portion, would lower the company’s income to common shareholders.

One typical example is a “bridge loan” a company may issue in anticipation of an IPO. Often, it involves different settlement scenarios, such as:

  • Conversion upon next round of equity financing,
  • Conversion or redemption upon IPO, and (or)
  • Change of control and settlement upon maturity.

Such instruments typically need both valuation for BCFs and an embedded derivatives analysis.

To fair value the related financial instruments, a key area is the appropriateness of the fair value assigned to the underlying shares connected with such transactions. Judgment is required when determining the fair value of inactively traded shares. As a result, a third-party valuation professional should be engaged to perform the analysis.

Liability Reclassification

Under SEC rules, certain financial instruments may need reclassification as a liability, such as mandatory redeemable shares. Particular attention must be given to warrants and preferred stock with such features.

Start Early to Finish Strong

Companies must consider these and other valuation requirements when navigating the rigorous IPO filing demands for their organization’s audited and unaudited financial statements. This includes ensuring the valuation requirements of the filing also comply with fair value standards when analyzing estimates for contingent assets or liabilities, embedded derivatives, and reclassification of complex financial instruments. Bear in mind, IPO filings may also require retrospective valuation analyses.

More often than not, the IPO terrain can be rocky and include unexpected hurdles. But with the support of expert trainers—beginning with an independent, third-party valuation professional—your company can find its peak shape in reaching its IPO marathon goals.

At any stage of the IPO process, we encourage you to contact the article author, Leon Li, or any member of VRC’s professional team, to discuss how our experts can deliver required valuation and advisory services to support your IPO.

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