Cheap Stock

Cheap stock refers to equity awards issued to employees ahead of a public offering at a value which is less than fair value to the IPO stock price. A company that has not yet issued public stock may issue equity awards to employees in the form of employee stock options (ESO) or restricted stock unit (RSU). These common forms of equity compensation for executives and other employees become “cheap stock” if the same securities are sold at a significantly higher price in the subsequent IPO.

Company stock that is not traded publicly and is granted as an award is valued based on internal accounting and valuations made by the firm, and often referred to as cheap stock. When a company decides to go public, a lengthy process begins that includes a Securities and Exchange Commission (SEC) review of offering documents. During its review, the SEC looks at stock-based awards granted during the most recently completed fiscal year and interim period. The SEC compares the estimated IPO price range provided by the company to a weighted average exercise price of equity awards and may issue comments asking the company to explain a change in value between the two.

Companies often disclose the IPO price range in a subsequent amendment to the preliminary prospectus, and this can further complicate accounting and comments from the SEC. One risk is that the company will have to record cheap stock charges on its income statement.