Before a company’s initial public offering (IPO) even begins trading on public markets, certain executives may already be positioned to reap significant financial rewards. This early advantage stems from the way stock options are priced in private companies prior to their public debut. Unlike public firms, where stock options are transparently valued based on market prices, private companies rely on subjective valuation models to estimate the fair value of shares. Because these models involve discretion and judgment, the exercise prices—the prices at which options can be converted into shares—may be set considerably below the eventual market value established once the company goes public.
When the company launches its IPO, the public market imposes an official stock price that often far exceeds the valuations used for option pricing in the private phase. As a result, stock options granted earlier, which appeared to be fairly priced “at the money,” become deeply “in the money,” effectively granting executives the ability to buy shares at exercise prices significantly lower than the true market price. This discrepancy acts as a form of “cheap money,” offering substantial financial gains even before any new operational achievements or company performance improvements. The phenomenon raises regulatory concerns because it distorts the economic reality of executive compensation and affects investor perceptions.
The U.S. Securities and Exchange Commission (SEC) routinely scrutinizes IPO registration documents for indications of these cheap stock grants. The practice potentially undermines the transparency and fairness of executive remuneration, obscuring the real economic cost of compensation. Understanding the scope, causes, and consequences of cheap stock options is therefore critical to market oversight, investor protection, and corporate governance.
In a groundbreaking study titled “Cheap stock options: Antecedents and outcomes,” forthcoming in Management Science, researchers led by Brad Badertscher, Deloitte Professor of Accountancy at the University of Notre Dame’s Mendoza College of Business, illuminate the expansive prevalence and significant economic implications of cheap stock options issued immediately before IPOs. Their work meticulously analyzes pre-IPO compensation structures and how they relate to post-IPO firm outcomes, providing empirical evidence that challenges simplistic narratives about stock option pricing in private markets.
The research reveals a startling statistic: on average, the IPO market price exceeds the exercise price of options granted in the fiscal year prior to the offering by more than fivefold. Such a wide gap is not simply a function of asset illiquidity or optimistic growth projections; instead, it is strongly influenced by structural incentives within the firm. These include the nature of venture capitalist involvement and management pay designs, indicating that cheap stock issuance is often a deliberate strategy rather than an accidental byproduct of valuation uncertainty.
By analyzing prospectuses from a large sample of 963 U.S. companies that went public from 2007 through 2022, the study quantifies this phenomenon and uncovers its multifaceted determinants. The size of the option grants, the scale of the company’s public offering, and the presence of top-tier venture capital backers all correlate with larger gaps between option exercise prices and the IPO price. Intriguingly, firms with vigorous monitoring mechanisms often exhibit higher incidences of cheap stock grants, complicating the narrative that these arrangements purely result from lax corporate governance.
Beyond just identifying the patterns, the research delves into the consequences of cheap stock option practices. The authors find that companies engaging in such pre-IPO option pricing tend to exhibit problematic behaviors afterward. For instance, CEOs in firms issuing cheap stock grants often receive compensation packages disproportionally generous relative to firm performance, signaling potential agency issues. These companies typically underperform in the public markets over the long term, spend less on growth initiatives, and deliver disappointing IPO results relative to expectations.
The study articulates a concerning dynamic in corporate leadership incentives, warning that entrenched CEOs who pocket substantial windfalls from cheap stock options may become complacent. With a vested interest in maintaining the status quo, these executives might avoid risk-taking measures essential for sustained shareholder value growth, thereby impairing corporate innovation and competitive positioning.
Such findings have broader implications for regulators, institutional investors, and compensation committees. The research validates the SEC’s unease regarding pre-IPO cheap stock compensation practices, underscoring that these grants can distort financial statements by understating compensation expenses and concealing true corporate incentives. This distortion is significant even in the absence of explicit fraudulent intent, challenging traditional accounting and audit frameworks.
For investors and market analysts, pre-IPO option pricing emerges as a valuable prognostic indicator. Scrutinizing the exercise prices and grant patterns of stock options before an IPO can provide early signals about a company’s future willingness to invest in growth and its potential for long-term success or failure as a publicly traded firm. Consequently, paying close attention to these compensation structures can improve investment decision-making and risk assessments.
From a governance perspective, the study urges boards and compensation committees to carefully weigh the embedded incentive distortions cheap stock options produce. While such grants may facilitate a smoother IPO launch, they carry long-lasting costs by embedding misaligned managerial incentives well beyond the transition to public markets. Revising compensation policies with greater transparency and alignment could help mitigate these unintended negative consequences.
Significantly, the research also sheds light on a typically opaque area of economic inquiry: private-firm valuation discretion. Since private companies are not subjected to market scrutiny, valuation processes involve considerable judgment and estimation, posing challenges for investors and regulators alike. By empirically documenting how this discretion translates into quantifiable financial windfalls during IPOs, the study contributes a crucial new perspective to understanding economic value creation and extraction in privately held enterprises.
This innovative work, authored by Badertscher in collaboration with co-researchers Bjorn Jorgensen from Copenhagen Business School, Sharon Katz from INSEAD, and Jeremy Michels from Purdue University, marks a substantial contribution to the literature on executive compensation, corporate finance, and market regulation. Their findings open promising avenues for future research, as well as practical interventions aimed at aligning executive incentives with shareholder interests more effectively.
As market participants and policymakers grapple with evolving IPO dynamics, this study highlights the intricate interplay between valuation, governance, and incentive structures, urging a more nuanced approach to managing and monitoring stock-based compensation at critical corporate junctures.
Contact: Brad Badertscher, Deloitte Foundation Department Chair of Accountancy, Mendoza College of Business, University of Notre Dame, Email: bbaderts@nd.edu
Subject of Research: The prevalence, determinants, and consequences of cheap stock options granted prior to IPOs.
Article Title: Cheap stock options: Antecedents and outcomes
News Publication Date: 1-Jan-2026
Web References: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4064057
References: Research conducted by Brad Badertscher et al., University of Notre Dame, Copenhagen Business School, INSEAD, and Purdue University.
Keywords: IPO, stock options, executive compensation, private firm valuation, corporate governance, venture capital, incentive misalignment, public markets, SEC regulation, financial disclosure, compensation expense, long-term performance
