Cheap Stock Options: Antecedents and Outcomes

The authors examine the prevalence, determinants, and consequences of cheap stock. “Cheap stock” refers to equity-based compensation valued at less than fair value. Cheap stock grants have drawn regulators’ attention, with the SEC frequently commenting on issues related to cheap stock when reviewing firms’ IPO registration statements. They 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. Cheap stock is greater for firms that grant more options, have larger public offerings, and have venture capitalist backing. Finally, cheap stock options are associated with greater IPO underpricing, lower post-IPO investment, higher CEO compensation, and lower financial reporting quality. Collectively, our results inform investors and regulators about the extent of cheap stock option grants and how these grants influence the post-IPO behavior of the firm.