On the Effect of Employee Stock Options on Credit Risk - A Credit Rating Agencies' Perspective

Abstract

This paper empirically examines whether and how credit rating agencies incorporate the information contained in outstanding employee stock options (ESOs) when assessing the credit risk of the issuing company. I hypothesize that outstanding ESOs play two informational roles in credit risk assessments - signaling equity infusion and predicting future repurchases - that help credit rating agencies evaluate the cash flow implications at the settlement of ESO contracts. My empirical analyses show that the fair value of outstanding ESOs has a negative impact on the issuer's credit rating after controlling for information risk, operating risk, incentive effects, and other known factors that affect perceived credit risk. This adverse impact is more pronounced for companies that repurchase shares in response to ESO exercise and is robust to the control of the endogenous choices of option issuance and ESO-related repurchases. Moreover, I find that the fair value change in outstanding ESOs subsequent to the grant date is incrementally informative about credit ratings beyond the grant date fair value. Collectively, these findings are consistent with the hypothesis that credit rating agencies incorporate in their credit risk assessments the information conveyed by outstanding ESOs about potential cash outflows associated with ESO-related repurchases. I do not find, however, that the present value of the expected proceeds from option exercise is associated with credit ratings. This latter finding suggests that credit rating agencies do not attach additional valuation on ESOs' promise to create future equity beyond the information that has been reflected in the fair value of outstanding ESOs.