Even before the opening bell rings on a company’s initial public offering, some senior executives may already be sitting on a substantial and largely invisible financial gain. Long before public investors have the chance to buy a single share, value can be quietly transferred to insiders through the way equity compensation is structured in the run-up to an IPO. This hidden windfall rarely attracts attention outside regulatory filings, yet it can materially shape incentives and outcomes once a company enters the public market.
An IPO can function as a source of “cheap money” because of how stock options are valued while a firm is still private. In principle, private companies are expected to grant options “at the money”, with exercise prices that reflect the fair value of the underlying shares at the time of the grant. In practice, the absence of a public market price means valuations rely on financial models and managerial judgement. That discretion gives firms considerable room to set option prices that later look extremely conservative.
When a company eventually goes public, the IPO establishes a market price that is often dramatically higher than earlier private valuations. Options that once appeared reasonably priced can instantly become deeply “in the money”, allowing executives and employees to buy shares at prices far below what new investors are paying. The resulting gap acts as a form of cheap money: a financial windfall created not by improved performance or innovation, but by the shift from opaque private valuation to transparent public markets.
This dynamic has long been a concern for regulators. The US Securities and Exchange Commission frequently highlights cheap stock grants when reviewing registration statements filed by companies seeking to list. The worry is not merely about fairness, but about whether compensation costs are being understated in financial disclosures, giving investors an incomplete or misleading picture of a firm’s true economics.
New research from the University of Notre Dame provides one of the most comprehensive examinations to date of how prevalent cheap stock is, what drives it and what it signals. The study finds that, on average, IPO prices are more than five times higher than the exercise prices of options granted in the fiscal year before listing. The authors show that cheap stock is not simply a by-product of growth, illiquidity or IPO uncertainty. Instead, it is strongly linked to specific incentives, including venture capital involvement and the design of executive pay.
Analysing prospectuses from 963 US firms that went public between 2007 and 2022, the researchers find that firms granting more options, conducting larger offerings and backed by venture capital tend to exhibit larger gaps between IPO prices and recent exercise prices. Crucially, cheap stock is also associated with weaker outcomes after listing. Companies that hand out heavily discounted options are more likely to overpay their chief executives, deliver disappointing IPO performance and spend less on growth, contributing to poor long-term share returns. The evidence suggests that executives who receive a sizeable IPO windfall may become less willing to take risks that serve shareholders’ interests.
Somewhat counter-intuitively, firms subject to greater monitoring by top-tier venture capitalists and prestigious underwriters often display more cheap stock just before going public. This points to a strategic motive: ensuring a smooth and successful IPO, even if it embeds distortions that linger afterwards. For regulators, investors and boards, the message is clear. Cheap stock can quietly reshape incentives, obscure actual compensation costs and offer an early warning signal about how a newly public company is likely to behave once the spotlight turns on.
More information: Brad Badertscher et al, Cheap Stock Options: Antecedents and Outcomes, Management Science. DOI: 10.2139/ssrn.4064057
Journal information: Management Science Provided by University of Notre Dame