Cheap Stock . . . 

is a securities term referring to company shares that were issued prior to a public offering at prices lower than the fair market value. The term is also used to refer to stock issued to founders and others at low prices that may, in fact, have reflected fair market value at the time but which, in the context of much higher public offering prices, later appear to have been sold at a discount.

A number of states impose restrictions on "cheap stock" issued to company promoters when the company conducts a public offering. The securities commissions in these states generally review stock issuances to company insiders during the three years prior to the public offering for the purpose of determining whether the stock was issued at less than its fair market value when it was sold. If the stock was issued at a steep discount to the proposed public offering price, one or more state securities commissioner may determine the stock to be "cheap stock" and impose conditions to the company conducting its offering in that state. The most common condition is to require holders of the "cheap stock" to escrow their shares for a period of time. The net effect is often to reduce the number of states in which a company qualifies to conduct its offering, thereby depriving the residents of states that are excluded of the opportunity to consider investing in a new company's public offering.

A different "cheap stock" issue can arise with the federal securities commissioners. At the federal level, the SEC can determine that options issued to company employees under a company’s incentive stock option plan were issued at exercise prices that were lower than fair market value at the time of issuance. In this case, a "cheap stock" determination can result in reclassification of qualified options as non-qualified. This can result in a charge to earnings for the company and a loss for the employee of the beneficial tax treatment afforded to qualified stock options. See: Bargain Stock, Blue Sky Laws, Going Public, ISOs (Incentive Stock Options), Qualified Stock Option Plans.