Study reveals hidden cost of ‘cheap stock’ IPO pay gap

Executives in certain companies may be experiencing a secret financial gain even before their initial public offerings hit the market. This windfall stems from a concept called “cheap money,” which is linked to the valuation of stock options before a company goes public. In private firms, options are typically granted “at the money,” aligning exercise prices with the fair value of shares at the time of the grant. However, without a public market price, these valuations heavily rely on models and subjective judgment, granting companies significant leeway in determining these values.

When a company finally transitions into a public entity through an IPO, the market value established often surpasses the previous private valuation by a substantial margin. As a result, options that were once considered reasonably priced can quickly become “in the money,” enabling executives to purchase shares at prices significantly lower than their market value. This discrepancy creates what is referred to as “cheap money,” representing a substantial financial gain generated by the shift from private to public valuations, rather than through actual performance improvements.

Regulators, including the U.S. Securities and Exchange Commission, frequently raise concerns about cheap stock grants during the review of registration statements by companies attempting to go public. Recent research conducted by the University of Notre Dame delves deep into the prevalence, determinants, and impact of cheap stock options. Lead author Brad Badertscher, the Deloitte Foundation Department Chair of Accountancy at Notre Dame’s Mendoza College of Business, highlights that, on average, the IPO price of a firm is over five times higher than the exercise price of options issued in the fiscal year preceding the IPO.

The research indicates that cheap stock option grants are not merely a result of high growth, lack of liquidity, or the uncertainty surrounding IPOs. Instead, they are driven by specific incentives such as the support from venture capitalists and how managers are remunerated. Firms that grant more options, have larger public offerings, or are backed by venture capital exhibit a more significant gap between the IPO price and the exercise price of recently granted options.

Parsing through detailed information from the prospectuses of 963 U.S. companies that went public between 2007 and 2022, the researchers discovered that companies distributing cheap stock options are prone to facing challenges. These challenges often manifest as overcompensation of CEOs, disappointing IPO results, and reduced investments in growth opportunities, leading to lackluster long-term stock performance. Entrenched CEOs may become complacent with the financial gains from the IPO, potentially hampering shareholder interests by avoiding risks that could benefit the company in the long run.

For investors, analysts, boards, and compensation committees, this study’s implications are critical. It validates regulatory concerns regarding the distortion of financial pictures caused by distributing cheap stock options pre-IPO, as well as the importance of examining pre-IPO pay structures as indicators of future performance. The study underscores the need for vigilance in recognizing potential incentive distortions that may persist long after the IPO event due to the embedding of cheap stock options.