What is Cheap Stock

Cheap stock refers to equity awards issued to employees ahead of an initial public offering (IPO) at a value far less than the IPO price.

A venture that is not yet a public company may compensate employees with employee stock options or restricted stock units. These common forms of equity compensation become "cheap stock" if later valued at a significantly higher price following an IPO.

Key Takeaways

  • Cheap stock refers to equity awards issued to employees before a public offering at valuations less than the IPO price.
  • They are common forms of equity compensation for executives and other employees.
  • Accounting for cheap stock can be problematic and may end up being registered as income on a company's balance sheet.

Understanding Cheap Stock

Pre-IPO companies will often grant to employees stock options as a form of compensation. The value of these awards are based on internal accounting and determinations made by the company, and often referred to as "cheap stock."

When a company goes public, a lengthy process begins that includes a Securities and Exchange Commission (SEC) review of offering documents. The SEC looks at stock-based awards granted during the most recently completed fiscal year and interim period. It 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. This is typically known as the "cheap stock" problem. One risk is that the company will have to record cheap stock charges on its income statement. Typically, companies employ valuation and accounting professionals to value stock.

Example of Cheap Stock

Taylor starts a new venture with their savings. Because they cannot match the attractive salaries offered by established companies, Taylor offers to employees stock options that will allow them to purchase the company's stock at a future date. The options are priced at $1 per share. Five years later, Taylor's company is successful and goes public. Bankers involved in the IPO price the company's shares at $10 per each. Employees at Taylor's company can thus cash out their cheap stock at a profit.