What is Cheap Stock?
The term “cheap stock” is used to describe equity awards that are given to employees prior to an IPO at a price significantly lower than the IPO price.
Employee stock options and restricted stock units are two forms of compensation that can be offered by a company that is not yet publicly traded. Common forms of equity compensation can be considered “cheap stock” if their value increases dramatically after an initial public offering (IPO).
KEY POINTS
- Equity awards given to employees prior to an initial public offering (IPO) at valuations lower than the IPO price are referred to as “cheap stock.”
- Executives and other employees frequently receive these types of equity compensation.
- Stock that is sold at a discount can be difficult to account for and may end up being recorded as income.
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Recognizing Cheap Stock
Stock options are a common form of compensation offered by pre-IPO companies to their employees. These grants are often referred to as “cheap stock” because their value is based on the company’s internal accounting and determinations.
A company’s offering documents must be reviewed by the Securities and Exchange Commission (SEC) before they can go public. The SEC reviews stock-based awards for the most recent fiscal year and any interim periods.
The firm may issue comments asking the company to explain a change in value between the estimated IPO price range provided by the firm and a weighted average exercise price of equity awards.
In a subsequent amendment to the preliminary prospectus, companies will typically disclose the IPO price range, which can further complicate accounting and comments from the SEC. The “cheap stock” issue is a common name for this situation.
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The possibility of recording charges for inexpensive stock on the income statement is a risk that the company faces. Companies typically employ stock valuation and accounting professionals.
Examples of Cheap Stock
Taylor invests their savings into a new business. Taylor offers employees stock options that will allow them to purchase the company’s stock at a future date in order to compete with the attractive salaries offered by established companies.
There is a $1 per share price tag attached to the options. Now, five years later, Taylor’s business has flourished and gone public. The IPO bankers set the share price at $10 per unit. Taylor’s employees can now profit from selling their cheap stock.
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