11th Hour Option Discounting: The Significance of IPO Prognostications in Fixing Equity Compensation

This paper examines the pervasive practice by pre-IPO firms of granting stock options as compensation while preparing to go public. These last-minute option grants, which are typically not contingent upon IPO completion, feature substantially lower exercise prices relative to the initial public offering (IPO) price, thus producing a windfall potential to executives and other option recipients once these firms consummate their IPOs shortly after having made these discounted option awards. I present empirical evidence to the effect that this 11th hour option discounting practice is common. I scrutinized the option grant practices of a hand-collected dataset comprising U.S. preclinical and clinical-stage biotechnology companies that pursued initial public offerings of common stock on a national stock exchange via registration on Form S-1 during the period from 2017 through 2021. The difference between the exercise prices of options awarded near the IPO and the IPO price at which firms offered their shares to the public shortly after making these option grants was substantial. Option holders enjoyed median and equal-weighted average discounts of 48% and 47% on the IPO price for 147 discounted option grants made during IPO preparations (weighted average: 48%). Almost half of these discounted options were awarded within 45 days prior to the first day of public trading. These last-minute discounted option awards were sizable. When aggregating the shares of common stock underlying the discounted option grants during IPO preparation with the shares of common stock offered by these firms in their IPOs, the total shares of stock underlying these option awards represented, on average, 8% of the total combined offering (median: 6%) per firm, albeit that the pre-IPO firms allowed option recipients to effectively purchase 8% of the total shares at a deep discount relative to the price at which they then offered the other 92% to the public, thus depriving firms of needed capital while significantly diluting IPO investors. IPO investors would expect that the equity compensation awarded to corporate insiders – the chief executive officer, other corporate officers, and the board of directors – as well as other key employees incentivized them to grow their firm’s equity value post IPO. Yet, corporate insiders received sizable equity awards at deep discounts on the IPO price just before their firms went public. For example, more than three-quarters (78%) of the firms in this study that granted discounted stock options during IPO preparation awarded heavily discounted options to corporate insiders, who, collectively, captured an average potential windfall of $4.2 million per firm. The average potential windfall per CEO alone came to $2.6 million. Firms routinely asserted in their securities filings and in their correspondence with the SEC that these option grants made in close proximity to their upcoming IPO were “at-the-money” even though the fair value they assigned to the underlying stock was substantially lower than the price at which they would offer shares to the public shortly after option grant. The average and median increases between option exercise price and IPO price were 124% and 92%. Current regulatory and accounting rules incentivize firms to keep the fair value of the stock underlying their last-minute option grants low to reduce option expenses and thus improve corporate earnings or reduce corporate losses. Option recipients are highly motivated to receive options with an exercise price equal to a low fair value of the underlying stock to avoid adverse tax consequences and benefit from a future windfall potential. The practice of 11th hour discounting is facilitated by glaring weaknesses in the regulatory framework. Pre-IPO firms exploit a seemingly quantitative stock valuation technique, the Probability-Weighted Expected Return Method. They conjure up exceedingly pessimistic prognostications as to IPO outcome, which allow them to set option exercise prices well below the price at which they sell shares to investors in their upcoming IPO. Pre-IPO firms often make incomplete and arguably misleading disclosures regarding their last-minute discounted option grants in their registration statements. Discounted awards made to corporate insiders during IPO preparations are often obscured. Prospective IPO investors expect pre-IPO firms to take measures during their IPO preparations to align the interests of management and employees with the interests of their new investors in the forthcoming IPO as these firms rapidly transition to public company status. I propose regulatory improvements to address 11th hour option discounting in order to correct the misalignment created by this practice and to ensure corporate insiders and their subordinates are incentivized to grow firm value post-IPO.