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SEC Has Questions, but Few Answers, About Undervalued Options

Internet start-ups often award cheap stock to their key talent before an IPO, but the SEC is taking a closer look at the increasingly common practice.

SAN FRANCISCO -- The Securities and Exchange Commission is waging a quiet war on the practice known as "cheap stock," in which start-ups undervalue stock options they grant to key employees before going public. But the protest from companies, especially Internet start-ups desperate for executive talent, is drawing more attention to the controversial practice.

Regulators are increasingly asking more companies to take compensation charges as they go public, including






Juniper Networks






Many of the start-ups argue that not only is the SEC hindering their prospects for luring top talent, it's offering too little guidance on valuing the options without invoking regulatory wrath.

"A lot of people are saying 'What's the SEC trying to do to us? Is the SEC trying to destroy us?'" says Geoff Yang, a partner at venture capital firm

Institutional Venture Partners


Cheap stock refers to the undervalued stock options granted to key employees before a company's IPO. To secure talent in an increasingly tight labor market glutted with Net start-ups, companies are offering generous heaps of pre-IPO stock options to bait a strong management team. The cheaper the stock options are priced, the bigger the cash windfall for execs if the company has a successful IPO.

The controversy surrounds the "fair value" a company places on itself when it values its options. Granting options below a company's market value is fine, as long as the difference between the market and the grant price is treated as compensation expense. But many IPO-bound companies low-ball the market value of options and fail to take the charge on their prospectus.

"Companies are pricing stock options at 60% to 80% discounts from preferred stock or the IPO price," says Mark Rubash, a partner in


global technology services group. And the SEC isn't buying it. If the valuation of stock options appears too low on a company's red herring, the SEC fires back with a "cheap stock charge."

Once it suspects shenanigans, the SEC calculates its own estimate of the stock option value, then it forces a company to book additional compensation expense for the difference. This amount is then amortized over the vesting period of the stock options, usually about four years.

eToys, for example, reported close to $60 million in deferred compensation in a 424B supplement to its prospectus. recorded $5.2 million as of March 31 and said in a recent filing it expects to record as much as another $31.7 million through July 15.

Most recent IPOs have smaller, yet still substantial, amounts of deferred compensations. Marimba recorded $3.2 million in deferred compensation as of March 31, according to SEC documents. Juniper recorded $7.5 million;

Redback Networks


, $8.9 million; and

Copper Mountain Networks


, $15.5 million. (


, which went public in May, recorded a total of $11 million in deferred compensation.)

"This is an extremely emotional issue. All these companies in the Valley are fighting for the best people," says Rubash. There aren't enough good people to go around, and now you've got this accounting issue with the potential of disrupting this good deal."

Companies want to be able to hedge these values with some confidence and avoid being stung after filing their initial prospectus; the charges tend to show up only in the amended prospectuses. Many companies are asking regulators for a formula or range of acceptable values.

"It would be great if the SEC could help us with coming up with a range of acceptable values or a safe harbor," says Frank Joyce, CFO of


, which took a $112,000 compensation charge. "It seems extremely arbitrary right now."

But the SEC says a setting a simple formula isn't as easy as it seems. Companies have objected to similar efforts at setting benchmarks in the past, since the needs of individual companies are different. "The valuation process is difficult," says Robert Bayless, chief accountant of the division of corporate finance at the SEC. "It has to be very fact-specific. Otherwise it's fair to a few, generous to some and punitive to others."

So companies have to take the hit. While many admit the practice has grown widespread, some feel unfairly targeted: "I think the pendulum has swung too far," says the CFO of a recently public Silicon Valley-based company who asked to remain anonymous.

In the meantime, ever-strategic financial wizards have found an easy way out. Many simply issue two sets of financial statements -- one according to generally accepted accounting principals, or GAAP, and another on a cash basis. This way, investors can see a company's operating results without the effect of noncash amortization expenses like the cheap stock charge. Chuck Robel, a partner at PricewaterhouseCoopers, estimates that about half of public companies report dual earnings via a supplemental set of financials, in footnotes to the GAAP financials or in press releases.

"I guess some of this is a lot of hot air," says Randy Bolten, CFO of



. "People can quibble, but it becomes more of a matter of disclosure. In some ways, the worse the cheap stock hit, the better, because the more obviously it can be segregated from the rest of your

operating results." Bolten says BroadVision took a compensation charge of about $2.5 million.

But there may be a reality check looming on the horizon for these companies. If the stock market experiences a sharp correction, companies stuck amortizing cheap stock charges may be viewed less favorably. If tech stocks start to tumble, those weighty charges could be harder to look askance at. "The risk is if the market changes," says Larson. "Will these companies be treated more negatively?"

Says Bayless of the SEC, "A lot of people with these stocks in their portfolio will be asking the same question."

Eileen Buckley holds no positions and has no business relationship with the companies mentioned in this story. She has written for TSC and is also a contributor to Wired News.