A Pre-IPO Gift for Corporate Executives: '11th Hour Option Discount'

Public companies must follow strict rules when granting stock options to their top executives, including pricing them where the company's shares are traded on the day they are granted and making them public promptly.

Private companies planning to go public face some of the same requirements, but have more leeway in pricing their stock options (since there is no publicly traded price) and more time to make them public.

That discrepancy has prompted dozens of private companies to give their top executives low-priced options in the weeks leading up to their IPOs — when they can often accurately predict where their shares are likely to trade, but before public corporate rules on option pricing kick in, according to a new research paper from Sven Riethmueller, a professor at Yale Law School.

“They're just shoving these stock grants in at the last minute,” Mr. Riethmueller said, referring to the options. He called the practice “eleventh-hour option discounting.”

In his paperMr. Riethmueller looked at 121 biotechnology companies that were on their way to an IPO between 2017 and 2021. He found that 74 companies had issued options to executives and employees in the 90 days before their public debut at an average discount of 48 percent to the IPO price.

Zoom, Beyond Meat and Eventbrite were among companies that also granted cheap stock options to their top executives and employees before going public. Mr. Riethmueller pieced together his findings by searching documents and obtaining non-public correspondence between the Securities and Exchange Commission and individual companies through the Freedom of Information Act.

Mr. Riethmueller found that by setting prices at the last minute, companies all but guarantee that winners will have a paper windfall on the first day of trading. This little-known practice has become extremely popular among young companies that often use cheap stock options as a way to lure top executives. Companies often do not announce the number of options given to individual managers until the evening before the trading day, after the IPO price has been set.

Less than a month before its initial public offering, a small Boston biotech company called Galecto issued its top executives nearly a million stock options, each priced at $7.70, which it disclosed in a filing.

What Galecto didn't make public until after the IPO price of $15 per share was set based on investor interest was that more than half of those deeply discounted options went to the company's CEO. When Galecto went public on October 28, 2020, the value of the CEO's options increased by $4 million.

By withholding information before the IPO price, Galecto denied investors the opportunity to accurately assess whether or not to purchase their shares at the $15 price. The information imbalance also prevented investors from fully assessing Galecto's compensation costs and whether the interests of its top managers aligned with theirs.

A Galecto spokeswoman, Sandya von der Weid, wrote in an email that the company could not issue the options earlier because it had to wait for a private financing round to close before determining their valuation. “These grants were recommended by an independent compensation consultant and approved by the Galecto board,” she added.

Stock options, which give the holder the right to periodically purchase shares of a company at a predetermined price over several years, are a popular part of senior executives' pay packages.

Under SEC rules, publicly traded companies can only issue stock options at market prices (or face draconian tax consequences) and must disclose them to top executives and other insiders within two days of granting them. By setting the so-called strike price of options at the market price, companies create incentives for executives to increase the value of the shares by the time the options vest; a higher stock price is generally good for all investors.

The rules were established after the options were introduced retroactively scandal from the mid-2000s, when companies had a long time horizon within which to report such rewards. In the late 1990s and early 2000s, more than a hundred companies set the date of options issues on days when their shares were at their lowest; This retroactivity allowed executives to reap greater financial rewards.

The timing ensured that their executives got paid immediately when the stock rose, putting them immediately in the money, at least on paper. The companies eventually became the subject of lawsuits and huge fines levied by the SEC. Some executives were sentenced to prison terms.

The SEC also requires robust disclosures from private companies about the stock options they grant to their top executives. However, unlike public companies, private companies are only required to disclose such details for each full financial year before going public. That reporting gap between filing their latest financial report and executing their IPO is the sweet spot when many pre-IPO companies are handing out cheap options and selectively disclosing information, Mr. Riethmueller found.

Zoom offered a discount of about 55 percent, according to its research, by offering options on January 24, 2019 for $16.02 and then again on February 28, 2019 for $16.72. When it went public on April 17, 2019, it sold shares to investors for $36.

Beyond Meat issued options at $20 per share on April 3, 2019, then went public at $25 on May 1, 2019; the 20 percent discount was less extreme.

Eventbrite issued options for $13.72 on July 24, 2018 and July 31, 2018, and then went public on September 19, 2018 at $23 per share. Mr. Riethmueller estimated that at the IPO price, Eventbrite had offered its CEO a potential windfall of $26.7 million based on the option to buy 2.9 million shares.

Representatives for the three companies declined to comment.

An SEC spokeswoman said executives who were granted options were required to disclose them before the first day of trading, including their exercise price and quantity. She declined to comment further on Mr. Riethmueller's findings.

Erik Lie, a finance professor at the University of Iowa who discovered stock option backdating, recently read Mr. Riethmueller's article. Mr. Lie said he saw parallels between backdated options at the time and the discounting options Mr. Riethmueller had excavated. “For me it's a simple game: you get the shares very cheap.”

In 2005, the SEC changed the rules around the disclosure and accounting of executive stock options in response to the Enron scandal, forcing companies to clearly mark stock options as part of overall compensation. After that, its use declined.

Todd Gormley, a finance professor at Washington University's Olin Business School in St. Louis, wondered whether private companies would still issue these pre-IPO options if they were more thoroughly disclosed to regulators and investors. “If it's not easy for someone to find out how much they paid, you behave differently when it's more transparent.”

For private companies, the SEC requires that options be priced based on calculations of an “expected market price” since there is no public trading. Private companies typically keep the SEC confidentially informed of their executive compensation figures in the run-up to their IPOs

But Mr. Riethmueller said the regulator rarely questioned a company's assumptions about how it arrived at the value of its shares or options, based on its review of confidential letters between the companies and the regulator. The SEC is behaving “like an absentee landlord,” he said.

Companies try to set a low expected market price to make the discounted options appear less blatant to regulators, Mr. Riethmueller said.

A popular way they lower the valuation is to say that there is a good chance they won't go public even if they are on the eve of their trading debut. In the confidential communication, companies explained their option pricing using a valuation method that took into account the potential price of their shares in an initial public offering, as well as the likelihood of them going public.

By taking into account the likelihood that they would not go public, they arrived at a lower, so-called blended, valuation of their target IPO share price.

Most companies estimate the chance of an IPO at around 60 percent – ​​even though in many cases these companies have already set a date to sound the alarm on the New York Stock Exchange or Nasdaq within a few weeks or months. (Of the 121 companies Riethmueller looked at, only five remained private.)

“Instead of properly preparing the company for the new public investors coming in, they are taking advantage by making inside deals at the expense of the new investors,” Mr. Riethmueller said.