Cheap Stock Options: Antecedents and Outcomes

We examine the prevalence, determinants, and consequences of cheap stock. Practitioners have adopted the label “cheap stock” to refer to equity-based compensation granted before a firm’s IPO that uses a share price below the IPO price. Cheap stock grants have drawn regulators’ attention, with the SEC frequently commenting on issues related to cheap stock when reviewing firms’ IPO registration statements. We find that the average firm’s IPO price is more than five times the exercise price of options issued in the fiscal year before the IPO. This divergence 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. Finally, cheap stock options are associated with higher CEO compensation, lower post-IPO investment, lower post-IPO stock returns, and greater IPO underpricing. Collectively, our results illustrate the extent of cheap stock option grants and how these grants influence firms’ post-IPO behavior.