Professor Sven Riethmueller on Pre-IPO Stock Option Discounting
In a new paper, Clinical Associate Professor of Law Sven Riethmueller examines the practice by pre-IPO companies of granting stock options as compensation while preparing to go public.
The paper, “11th Hour Option Discounting: The Significance of IPO Prognostications in Fixing Equity Compensation,” looks at a dataset comprising 121 U.S. preclinical and clinical-stage biotechnology companies that pursued initial public offerings from 2017 to 2021.
Riethmueller presents empirical evidence that the practice of granting deeply discounted options during IPO preparations to executives, directors, and employees just before their company goes public is common — what he terms 11th hour option discounting practice.
The New York Times covered the new paper, writing that Riethmueller “found that by pricing options at the last minute, companies nearly guarantee that awardees will have a paper windfall on the first trading day.”
The average potential windfall per CEO alone came to $2.6 million in Riethmueller’s analysis.
11th hour option discounting has largely avoided scrutiny by regulators, corporate governance watchdogs, and other market observers, according to Riethmueller. In the paper, he proposes reforms of outdated regulations and other factors that facilitate these practices.
At the Law School, Riethmueller is the inaugural director of the Entrepreneurship & Innovation Clinic. Prior to founding the clinic, he was in private practice, including as a law firm partner, and practiced in-house, including as the general counsel of a publicly traded life sciences company. Key findings from his research on 11th hour option discounting can be found on the clinic’s website.
How did you become interested in this topic?
How to structure equity incentives that drive innovation is a key research interest for me.
I previously published a paper, titled Rise of the Zombies: The Significance of Venture Capital Investments That Are Not Profitable that among other things, looked at the use of stock options for employees in venture capital-backed companies to incentivize start-up employees.
For this paper, I focused on the option grant practices by companies that are about to go public in an IPO. Prospective IPO investors would expect these pre-IPO companies to take measures during their IPO preparations to align the interests of management and employees with the interests of their new investors as these firms rapidly transition to public company status. Equity compensation, such as stock options, is considered a critical tool for incentivizing executives and key employees to grow a company’s value for the benefit of its stockholders.
If these companies granted options with option exercise prices that equaled or at least closely approximated the IPO price to be paid by IPO investors, the company’s management and employees receiving these options may well be incentivized to grow the company’s equity value post-IPO for the benefit of these IPO investors.
My research, however, found that companies frequently awarded sizable stock options with deeply discounted exercise prices on the IPO price while they are actively preparing for the IPO, which allows company insiders and other option recipients to benefit from a future windfall potential even if the stock does not rise.
What are some of your paper’s key findings?
My paper presents empirical evidence to the effect that the practice of granting deeply discounted options during IPO preparations to executives, directors, and employees just before their company goes public is pervasive. I call this practice 11th hour option discounting.
I scrutinized the option grant practices of a hand-collected dataset comprising 121 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.
However, 11th hour option discounting is not limited to biotechnology companies. My paper also presents late-stage equity awards made by the 15 companies from different industries that went public during the 2017–2021 period.
Companies make last-minute option grants during their IPO preparations that feature substantially lower exercise prices relative to the IPO price. 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.
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. More than three-quarters 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.
What did your research and analysis involve?
I focused on pre-clinical and clinical-stage biotechnology companies seeking to go public in the U.S. during 2017–2021 who, under the widely used market-oriented industry classification scheme known as The Refinitiv Business Classifications (TRBC) scheme, were pursuing “Bio Therapeutic Drugs” as their principal business activity at the time of initial public filing of their draft registration statement on Form S-1 with the SEC. TRBC sector classifications are designed to enable peer company comparisons, which allowed me to compare similarly situated companies in this segment of the biotechnology market and sort IPO candidates while minimizing selection bias.
I refined these results based on certain exclusion criteria and ended up with a hand-collected dataset comprised of 121 companies.
My data were collected from the SEC filings and submissions of the 121 companies in my study, as well as the 15 companies sampled from different industries that went public during the study period, including their draft registration statements and all subsequent amendments, final prospectus filings, proxy statements, and annual and quarterly reports, as well as the disclosures of securities ownership by firm insiders, all of which are available on the SEC’s EDGAR database. In addition, data were collected from correspondence sent by firms in this study to the SEC, including concerning stock valuations. This correspondence, which was routinely redacted by the firms, is also available on EDGAR.
I obtained unredacted originals of this correspondence from the SEC under the Freedom of Information Act (FOIA). Altogether, I submitted FOIA requests for unredacted SEC correspondence for 52 firms in this study starting in October 2022. As of Sept. 15, 2023, the SEC had produced the unredacted or partially unredacted correspondence from 37 firms.
I also provided illustrations of 11th hour option discounting practices by the 15 non-biotechnology companies from different industries that went public during the 2017–2021 period: Zoom Video, Roku, Peloton Interactive, Eventbrite, Beyond Meat, Upwork, Gitlab, Snowflake, Slack, Toast, Unity Software, Smartsheet, Bill Holdings, Root, and The RealReal.
What is the path forward? Are there solutions you suggest?
I found that the practice of 11th hour discounting is facilitated by glaring weaknesses in the regulatory framework. 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.
Moreover, the recipients of these option awards 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.
Pre-IPO companies can exploit a seemingly quantitative stock valuation technique, the Probability-Weighted Expected Return Method (PWERM). They conjure up exceedingly pessimistic prognostications as to IPO outcome. These low probabilities are then used to set option exercise prices well below the price at which these companies sell shares to investors in their upcoming IPO. Moreover, companies will use much earlier valuations with low IPO outcome probabilities to set the exercise price of stock option awards they make just before the IPO.
In addition, I found that 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 in the securities filings preceding the IPO.
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 therefore propose regulatory improvements to address 11th hour option discounting to correct the misalignment created by this practice and ensure corporate insiders and their subordinates are incentivized to grow firm value post-IPO.
I propose critical reforms of outdated regulations and accounting rules that facilitate 11th hour option discounting practices to ensure that the exercise prices for late-stage stock options are not set at a deep discount to the IPO price and that pre-IPO equity awards made so close to the IPO are transparent to IPO investors.
These include disqualifying the PWERM as a valuation methodology for these late-stage option grants, setting exercise prices for stock option grants near the IPO at the midpoint of the preliminary IPO price range, significantly expanding disclosure obligations under securities regulations to improve transparency for firms granting compensatory stock options near a planned IPO, including with respect to all corporate insiders and other key employees, and corresponding revisions to federal regulations and accounting standards.