Taking a company public can be a long and difficult process. An IPO can easily take a year or more to complete, and the preparations can begin long before a formal S-1 is filed. Then, once filed, an S-1 has to be scrutinized and formally approved by the SEC. This review and comment process is similar to a routine 10-Q or 10-K conversation, only it can take longer and be more involved. In both cases, comment letters between the SEC and the company are used as a way to raise and resolve questions and concerns the regulator might have for the prospective registrant.
In this blog, we will take a look at some of the most common areas questioned by the SEC during reviews of S-1 IPO forms over the past three years.
The pre-IPO registration statement is typically the first publicly available document to contain a detailed description of the company’s financial position and results of operations. As such, it should come as no surprise that this document would be subject to a very extensive regulatory review. The first letter issued by the SEC is often quite long – the longest we have seen had nearly 200 comments – with the number of questions dropping sharply after the first round of comments. The entire review process can take as many as 10 rounds to complete.
Below we introduce a couple metrics that can be used to shed light on the length and level of detail of the pre-IPO review process.
- Average Number of Comments in First Letter: This metric provides a benchmark for the initial review. More comments could mean a more thorough review, more complex operations and accounting, or a lack of clarity on the part of the issuer.
- Average Number of Days between First Letter and IPO: This metric acts as a proxy benchmark for the overall S-1 review. Unlike 10-K and 10-Q letters, there is no “closing” letter for registration statements. Instead, companies are granted permission to declare the registration effective. For that reason, we used the number of days between the 1st letter in the conversation and the IPO date as a rough measure of the length of the review process.
In the following table, we provide the results of applying these metrics to S-1 IPO comment letters from 2013 to 2015.
As we can see, the number of days was relatively flat for all three years. The number of the first-round comments, however, appears to have declined between 2013 and 2015, dropping from 39 to 27. Outliers in certain industries or of a certain size can affect the results. For example, the longest letter during the period under review was for Yulong Eco-Materials Ltd, with 121 comments; more than 4 times the average.
Do certain types of questions predominate in S-1 comment letters? Are they different from what we have seen in 10-K and 10-Q letters? Before delving into these questions, we would like to point to a publication issued by Deloitte in October 2015 that analyzes comment letter trends. Pages 102 to 109 of the publication, “SEC Comment Letters – Including Industry Insight”, are devoted entirely to registration statements. The list of the registration-specific topics discussed include questions related to the age of financial statements (based on Rule 3-12 of Regulation S-X); carve-out financial statements and compliance with Rules 3-05 and 3-09 of Regulation S-X; proper presentation of pro forma information (Article 11 of Regulation S-X); and proper presentation of net tangible value in the dilution section (Rule 506 of Regulation S-K).1
In the table below, we provide a detailed breakdown of the accounting-type issues most commonly in the first round of review of S-1s declared effective between 2013 and 2015.2 (Of 597 companies fitting this criteria, only 7 did not have any comment letters related to their prospectus).
As we can see from the table above, almost half of the IPO companies received at least one question related to share-based compensation.3 In many cases, the concerns raised were related to the valuation of pre-IPO stock awards, and the difference between IPO and stock grant prices:
“We may have additional comments on your accounting for equity issuances including stock compensation and beneficial conversion features. Once you have an estimated offering price, please provide us an analysis explaining the reasons for the differences between recent valuations of your common stock leading up to the IPO and the estimated offering price.”
Debt related topics, the second most common issue, ranged from the classification of instruments as debt or equity to the long term classification of debt instruments.
Revenue recognition was the third most common. The specific topics ranged from determination of VSOE and establishment of separate units of accounting to the determination of appropriate time frame over which revenue is recognized:
“We note that your hardware contains firmware essential to the functionality of the connected health and fitness devices. We further note from your website that you provide free product enhancements and bug fixes via firmware updates. Please tell us whether you believe these firmware updates represent a separate unit of accounting. We refer you to the guidance in ASC 605-25.”
Some comments, such as those related to the valuation of debt and equity securities, could be found across all the industries. Other issues, on the other hand, were more prevalent in certain sectors. For example, questions related to research & development were particularly common among pharmaceutical and biotechnology companies:
“Please revise your disclosure to provide a break out of outsourced research and development expense by development compound for each period presented and for inception to date.”
The list above is not comprehensive and is intended to give a handful of examples. As noted in the Deloitte publication, there are a number of non-accounting areas which are of interest to the SEC. We attempted here to provide insight into the most common accounting-related areas, whereas many comments deal with unique, company-specific transactions or disclosures.
We are not aware of any research that provides evidence of a correlation between the length of the review process and the future success (or failure) of the registering company. Nevertheless, we suspect that in some cases a lengthy delay might have prevented a company from taking full advantage of more favorable market conditions in 2013 and 2014 by dragging the IPO date into what was a much less favorable market in 2015.
1. For additional resources related to trends in comment letters, see also the “Technical Line” released by EY in September 2015. Industry-specific reports released by the audit firms also provide an excellent source of information.↩
2. The table covers selected topics based on Audit Analytics internal classification and is not comprehensive.↩
3. This topic is covered in depth on page 54 of Deloitte’s “SEC Comment Letters – Including Industry Insight”.↩