CEO compensation and the reported value of stock options in initial public offerings

Abstract

Purpose – This paper aims to test the effects that different compensation policies have on managerial discretion with regard to stock options. Design/methodology/approach – Hand-collected data from Securities and Exchange Commission registration statements are used to analyze the effects of chief executive officer (CEO) compensation policies on managerial discretion used in valuing stock options. Findings – This paper provides evidence that during the height of the initial public offering (IPO) bubble, CEO pay was associated with the undervaluation of stock options by IPO firms. The discretion varies with the relative mix of cash vs stock-based compensation. Firms with higher cash compensation tend to undervalue the unobservable market price of pre-IPO shares, leading to lower option values and a lower likelihood of reporting in-the-money options. Firms with greater stock-based compensation understate stock volatility, resulting in lower measures of the time-value component of options. Practical implications – The results provide evidence that firms attempted to disguise the true value of CEO pay when making IPOs. By disguising the value of options granted to the CEO, outsiders were not aware of the actual cost incurred and the true value of the company. Originality/value – This paper is the first to document that IPO firms understate the non-observable market price of pre-IPO shares to manipulate the value of stock options. It also documents the effect of discretion in estimates of volatility on stock options and the link between this discretion and CEO compensation.