Between August and February of 2011, Pandora Media granted over six million stock options, each with an exercise price of $3.14. Pandora stated this exercise price was greater than or equal to the fair market value of its common stock. Five months later, on June 14, 2011, Pandora completed its initial public offering (IPO), issuing stock at $16 per share. These prices imply growth of over 400% in just five months.
This anecdote is far from unique. Companies commonly grant equity-based compensation, such as stock options, before completing a public offering. However, these companies have substantial discretion in determining this compensation’s fair value as their stock does not have a price quoted on a public exchange. When companies value this compensation using a stock price below the IPO issue price, it is referred to as “cheap stock.” Cheap stock is at the forefront of the Security and Exchange Commission’s (SEC) review during the IPO process. In fact, the SEC raises issues related to cheap stock – as they did during Pandora’s IPO – more frequently than any other topic.
In our recent paper, we propose several potential explanations for the prevalence of cheap stock. First, we consider the possibility that firms accurately value pre-IPO cheap stock. In this case, rapid growth in firms choosing to IPO would cause the divergence between the IPO price and pre-IPO valuations. However, the magnitude of the difference between pre-IPO values and the IPO offer price suggests that firm growth alone is unlikely to explain cheap stock. Specifically, we find that IPO prices are on average more than five times the exercise price of options granted in the year preceding the IPO. We also adjust pre-IPO values to undo the discount applied to private firms for their lack of liquidity and control for growth in the pre-IPO firm using estimated growth rates from similar public companies. Even with these adjustments, we still find that the IPO price is significantly greater than the pre-IPO value.
Second, we propose that companies grant cheap stock to increase reported earnings. Since cheap stock undervalues compensation expense, it results in higher reported earnings. Consistent with companies using cheap stock to manage earnings, we find that the firms, on average, avoid a compensation expense equal to $0.12 per share by using cheap stock. We also find that companies that use cheap stock are more likely to restate their financial statements. This finding suggests that cheap stock may reflect a lower overall quality of financial reporting.
Third, we argue that some shareholders in private companies may be particularly motivated to take these companies public. The compensation represented in cheap stock is most valuable after the firm completes an IPO. Thus, shareholders could use cheap stock to motivate the company’s managers to take the firm public. Consistent with this motivation, we find some evidence that large shareholders, including venture capitalists, are associated with cheap stock.
Fourth, we conjecture that companies that use cheap stock may have weaker corporate governance structures. Lax oversight of the company’s managers could allow them to extract excessive compensation. While we do not find that corporate governance measures are significant determinates of cheap stock issuance, we do find evidence that cheap stock options are associated with corporate governance-related outcomes. Specifically, we find that CEOs of companies using cheap stock received higher total compensation when we value this compensation using the IPO issue price (i.e., when it is not valued “cheaply”). We also find that companies with cheap stock invest less following the IPO. This finding suggests that CEOs receiving cheap stock compensation may not be motivated to take on risky but valuable investments. Finally, we find CEOs receiving cheap stockare less likely to leave the company in the years following the IPO, consistent with these CEOs being more entrenched and thus less susceptible to turnover.
Overall, we document that cheap stock is prevalent and can significantly affect a company’s reported compensation expense. Further, we show that cheap stock is not purely a financial reporting issue. The incentives that cheap stock provides shape firm actions, such as investment decisions.
Brad A. Badertscher is the Deloitte Professor of Accountancy at the Mendoza College of Business at the University of Notre Dame.
Bjorn Jorgenson is a Professor of Accounting at the Copenhagen Business School.
Sharon P. Katz is an Associate Professor of Accounting and Control at INSEAD.
Jeremy Michels is an Assistant Professor of Accounting at the Wharton School in the University of Pennsylvania.
This post is adapted from Brad A. Badertscher, Bjorn Jorgensen, Sharon P. Katz, and Jeremy Michels, “Cheap Stock Options: Antecedents and Outcomes,” available on SSRN.
The views expressed in this post are those of the authors and do not represent the views of the Global Financial Markets Center or Duke Law.
