IPO pay gap hiding in plain sight: Study reveals hidden cost of ‘cheap stock’
Before the opening bell ever rings on a company’s initial public offerings, some of the executives may already be sitting on a quiet windfall.
An IPO can act as a source of “cheap money” because of how stock options are valued before a company goes public. In private firms, options are supposed to be issued “at the money,” with exercise prices reflecting the fair value of the shares at the time of the grant. But without a public market price, those valuations rely on models and judgment, giving companies wide discretion.
When the firm later goes public, the IPO establishes a market value that is often far higher than the earlier private valuation. Options that once appeared fairly priced can suddenly become deeply “in the money,” allowing executives to purchase shares at prices far below market value. The resulting gap functions as “cheap money” — a significant windfall created by the shift from private valuation to public markets, rather than by new performance.
This is a red flag for regulators. The U.S. Securities and Exchange Commission frequently flags cheap stock grants when it reviews registration statements when companies try to go public.
New research from the University of Notre Dame examines the prevalence, determinants and consequences of cheap stock.
“The average firm’s IPO price is more than five times the exercise price (price per share when stock options are exercised) of options issued in the fiscal year before the IPO,” said lead author Brad Badertscher, the Deloitte Foundation Department Chair of Accountancy and Deloitte Professor of Accountancy at Notre Dame’s Mendoza College of Business. His findings in the paper titled “Cheap stock options: Antecedents and outcomes” are forthcoming in Management Science.
“We show that ‘cheap stock’ option grants are widespread and economically significant,” Badertscher said. “It isn’t just about high growth, lack of liquidity or IPO uncertainty. It’s actually driven by specific incentives — like backing from venture capitalists and how managers are compensated.”
The gap between the IPO price and the exercise price of recently granted options is greater for firms that grant more options, have larger public offerings and have venture capital backing.
Badertscher, with co-authors Bjorn Jorgensen from Copenhagen Business School, Sharon Katz from INSEAD and Jeremy Michels from Purdue University, analyzed the prospectuses of 963 U.S. companies that went public between 2007 and 2022, pulling detailed information on pre-IPO stock option grants. The researchers’ main metric measured the gap between the IPO price and the average employee exercise price in the fiscal year immediately preceding the IPO.
They found that when a company gives out cheap stock options, it tends to signal trouble. It’s linked to overpaying the CEO, a disappointing IPO and less money being spent on growth — leading to poor long-term stock performance.
The paper states, “Entrenched CEOs, having received a financial windfall from the IPO, may prefer the status quo and may not be motivated to take risks that are in the best interest of shareholders.”
Companies with more monitoring — like top-tier venture capitalists and underwriters — often have more cheap stock right before going public. This suggests they are doing it to guarantee a successful IPO, not just because of poor corporate governance.
The study has implications for regulators, investors, boards and researchers.
It validates the SEC’s concern that handing out cheap stock before an IPO can make compensation expenses look way lower than they actually are, which distorts the financial picture, even absent clear evidence of fraud.
For investors and analysts, the research shows that looking at pre-IPO pay structures gives you a sneak peek into how well a company will perform and invest once it’s on the public market. For boards and compensation committees, it suggests that cheap stock can embed long-lasting incentive distortions that extend well beyond the IPO event.
“The paper also opens a new empirical window into private-firm valuation discretion, an area that is typically unobservable but economically important,” Badertscher said.
Contact: Brad Badertscher, 574-631-5197, bbaderts@nd.edu
Journal
Management Science
Article Title
Cheap stock options: Antecedents and outcomes
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