Granting and Hedging Employee Stock Options: A Tax Motivation and Empirical Tests

Abstract

We present a tax motivation for the use of employee stock options (ESO) in compensation schemes, based on the advantageous treatment allowed for a firm hedging positions written on its own securities. In a binomial option framework, we show that a cost saving on the order of 10-15% of compensation can be achieved if a company hedges its ESO liability by repurchasing its own shares and issuing debt in a dynamic manner. The financial and popular press has noted both an increase in ESO usage and a tendency by firms to repurchase their shares. It is presumed that the objective of firms' stock repurchases is to hedge their ESO positions and avoid further diluting the stakes of their non-ESO shareholders. However, classic finance paradigms suggest that in the absence of informational effects and market frictions, (preventing) dilution should have little or no impact on the wealth of shareholders. Our model indicates that the stock repurchases and debt related tax benefits associated with hedging activity should favorably impact share prices, thereby providing a value- based justification for reducing dilution. Empirical results we present are consistent with our model. In particular, the data show that ESO usage is positively related to leverage increases and to share repurchases. In addition, although research has found that stock repurchases tend to follow price declines, we find that pre-repurchase stock rates-of-return are greater for firms with more ESO. This finding is expected in a hedging framework, since option values and share repurchases tend to increase with share prices.