Are You Aware Of The Danger Hidden Within IPOs?

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Warning of tech-bubble-like overvaluation in the IPO market, we’ve previously put recent IPO companies Wayfair (W), Box (BOX) and GoDaddy (GDDY) in the Danger Zone. This week we’re turning the tables and putting IPO investors in the Danger Zone as we reveal many of the hidden dangers of IPO investing today.

Accounting Loopholes for Pre-IPO Companies

Most investors do not know that accounting rules are different for pre-IPO companies than for post-IPO companies.

Possibly the biggest difference is in the treatment of employee stock compensation, which creates a loophole that enables companies to drastically understate option expense and overstate earnings in their pre-IPO filings. Because there is not yet an “official” value for the company’s shares, options grants are recorded at highly understated values, especially relative to IPO prices. For instance, Guidewire (GWRE) reported option expense of $6,680,000 in 2011. One year later, GWRE reported option expense of $18,258,000 after the company went public despite the number of options granted halving over the same time.

Proof of the this misleading practice manifests when, immediately following the IPO, stock compensation expense shoots off the chart as the company has to eventually recognize the more appropriate cost for the pre-IPO stock compensation. As can be seen in Figure 1, Groupon (GRPN), a previous Danger Zone stock, had stock-based compensation expense increase from only $115,000 in 2009, two years before its IPO to $93,000,000 in 2011 after going public. The irony here is that the number of options granted declined precipitously from 14,500,000 in 2009 to 158,000 in 2011. Meanwhile the reported accounting option expense skyrocketed.

Figure 1: Groupon Stock Based Compensation Post IPO NewConstructs_GRPN_ESOexpense

Sources: New Constructs, LLC and company filings

Limited And Conflicted Disclosure Is A Red Flag

Under the JOBS Act, any company with gross revenues below $1 billion is subject to less stringent reporting requirements. “Emerging growth” companies receive the following disclosure “benefits”:

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Disclosure: New Constructs staff receive no compensation to write about any specific stock, sector, or theme.

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