Stock Option Grants Research Articles

Incentives from stock option grants: a behavioral approach

PurposeThis paper aims to analyze the valuation of stock options from the perspective of an employee exhibiting preferences as described by cumulative prospect theory (CPT). In addition, it elaborates on their incentives effect and some implications in terms of design aspects.Design/methodology/approachThe paper draws on the CPT framework to derive a continuous time model of the stock option subjective value using the certainty equivalence principle. Numerical simulations are used in order to analyze the subjective value sensitivity with respect to preferences‐related parameters and to investigate the incentives effect.FindingsConsistent with a growing body of empirical and experimental studies, the model predicts that the employee may overestimate the value of his options in‐excess of their risk‐neutral value. Moreover, for typical setting of preferences parameters around the experimental estimates, and assuming the company is allowed to adjust existing compensation when making new stock option grants, the model predicts that incentives are maximized for strike prices set around the stock price at inception. This finding is consistent with companies’ actual compensation practices. Finally, the model predicts that an executive who is subject to probability weighting may be more prompted than a risk‐neutral executive to act in order to increase the firm's assets volatility.Originality/valueThis research proposes an alternative theoretical framework for the analysis of pay‐to‐performance sensitivity of equity‐based compensation that takes into account a number of prominent patterns of employee behavior that expected utility theory cannot explain. It contributes to recent empirical and theoretical researches that have advanced CPT framework as a promising candidate for the analysis of equity‐based compensation contracts.

Pricing of a reload employee stock option under severance risk

Since employee stock option grants have some features that do not fulfill the Black–Scholes assumptions, we use a severance incorporating model to capture its main properties that specify the price and reload condition. Generally, the employee is exposed to various severance risks such as termination with cause or without cause. Departure from a firm with or without cause means that the option would be forfeited or exercised immediately, respectively, which gives significant influence to the optimal decision of executing the reload. To compute the reload, we determine the boundary constraint as a free boundary condition and reveal the main features of the impact of severance risk on reload.

Employee Stock Options Incentive Effects: A CPT-Based Model

This paper examines the incentives from stock options for loss-averse employees subject to probability weighting. Employing the certainty equivalence principle, I built on insights from Cumulative Prospect Theory (CPT) to derive a continuous time model to value options from the perspective of a representative employee. Consistent with a growing body of empirical and experimental studies, the model predicts that the employee may overestimate the value of his options in-excess of their risk-neutral value. This is nevertheless in stark contrast with a common finding of standard models based on the Expected Utility Theory (EUT) framework that options value to a risk-averse undiversified employee is strictly lower than the value to risk-neutral outside investors. In particular, I proved that loss aversion and probability weighting have countervailing effects on the option subjective value. In addition, for typical setting of preferences parameters around the experimental estimates, and assuming the company is allowed to adjust existing compensation when making new stock option grants, the model predicts that incentives are maximized for strike prices set around the stock price at inception. This finding is consistent with companies’ actual compensation practices that standard EUT-based models have difficulties accommodating their existence.

The Valuation Differences Between Stock Option and Restricted Stock Grants for US Firms

Abstract: In this study, we document a significant shift over the past several years from stock option‐based compensation to restricted stock‐based compensation. Additionally, we evaluate whether stock option grants and restricted stock grants result in similar valuation consequences for firms. We estimate cross‐sectional valuation equations that include the value of stock option and restricted stock grants summed over the current and past two years, residual income, and book value of equity, after controlling for endogeneity. Consistent with prior research, our findings indicate that the market on average values stock option grants positively. However, in contrast to stock option grants, restricted stock grants are valued negatively. This result is consistent with restricted stock grants lacking the positive incentive effects of stock options and being viewed as a liability or expense to the firm.

Corporate Governance and Earnings Management in the Pre– and Post–Sarbanes-Oxley Act Regimes

Backdating stock options, a practice that retroactively adjusts stock option grant dates to lower the exercise price, has raised governance, legal, accounting, tax, and auditing concerns. The practice of backdating options generally is believed to be a result of both ineffective corporate governance and management opportunism. Both of these factors have been linked to a higher level of discretionary accruals adjustments. This study examines the accruals-based earnings management patterns for a group of firms that were implicated by the Securities and Exchange Commission (SEC) for backdating stock options with a matched control group of nonimplicated firms for a time period surrounding the enactment of the Sarbanes-Oxley Act (SOX) of 2002. Both the univariate and multivariate analyses show that in the pre-SOX years, the sample of implicated firms managed abnormal accruals at a significantly greater level than the matched group of nonimplicated firms. The differential pattern of accruals management across these two groups becomes insignificant in the post-SOX period. Our result also suggests that the effect of SOX on mitigating the level of accruals management is substantially greater for the implicated companies than for the nonimplicated companies. The difference in the effect of SOX on the two groups of firms persists even after controlling for the differences in their governance and internal control effectiveness. We, therefore, suggest that SOX had effects on management’s reporting choices beyond those resulting from improvements in governance and internal control over financial reporting.

The Option to Quit: The Effect of Employee Stock Options on Turnover

We show that in the years following a large broad-based employee stock option (BBSO) grant, employee turnover falls at the granting firm. We find evidence consistent with a causal relation by exploiting unexpected changes in the value of unvested options. A large fraction of the reduction in turnover appears to be temporary with turnover increasing in the 3rd year following the year of the adoption of the BBSO plan. We also find that the effect of BBSO plans is larger at market leaders, identified as firms with high industry-adjusted market-to-book ratios, market share or industry-adjusted profit margins, as measured at the time of the grant.

Stock option grants to target CEOs during private merger negotiations

Unscheduled stock options to target chief executive officers (CEOs) are a nontrivial phenomenon during private merger negotiations. In 920 acquisition bids during 1999–2007, over 13% of targets grant them. These options substitute for golden parachutes and compensate target CEOs for the benefits they forfeit because of the merger. Targets granting unscheduled options are more likely to be acquired but they earn lower premiums. Consequently, deal value drops by $62 for every dollar target CEOs receive from unscheduled options. Conversely, acquirers of targets offering these awards experience higher returns. Therefore, deals involving unscheduled grants exhibit a transfer of wealth from target shareholders to bidder shareholders.

A Dual Role for Restricted Stock Grants

Restricted stock grants are generally modeled as an alternative incentive creation device to stock option grants. Given that incentive option grants are not dividend-protected while restricted stock grants carry dividend entitlements, we propose a dual role for restricted stock when granted simultaneously with options. We find that CEOs of dividend-paying stocks who are incentivized by option grants are effectively protected against dividend risk by simultaneous grants of restricted stock. We further show that the hedge rationale empirically dominates a delta maintenance rationale that follows when firms seek to maintain the option delta for the option term. Our evidence has major implications for all models and empirical analyses that assume restricted stock grants operate purely as incentive devices.

CEO stock options and analysts’ forecast accuracy and bias

This paper investigates the relationship between CEO stock options and analysts’ earnings forecast accuracy and bias. A higher level of stock options may induce managers to undertake riskier projects, to change and/or reallocate their effort, and to possibly engage in gaming (such as opportunistic earnings and disclosure management). These managerial behaviors result in an increase in the complexity of forecasting and hence, less accurate analysts’ forecasts. Analysts’ optimistic forecast bias may also increase as the level of stock options pay increases. Because forecast complexity increases with stock options pay, analysts, needing greater access to management’s information to produce accurate forecasts, have incentives to increase the optimistic bias in their forecasts. Alternatively, a higher level of stock options pay may lead to improved disclosure because it better aligns managers’ and shareholders’ interests. The improved disclosure, in turn, may result in more accurate and less biased analysts’ forecasts. Our empirical evidence indicates that analysts’ earnings forecast accuracy decreases and forecast optimism increases as the level of CEO stock options increases. This evidence suggests that the incentive alignment effects of stock options are more than offset by the investment, effort allocation and gaming incentives induced by stock options grants to CEOs.

An Examination Of The Effectiveness Of CEO Stock Option Granting Decisions Toward R&D Investments?

Stock options are used to motivate investments in risky projects, such as R&D investments. When compensation committees make granting decisions to stimulate R&D spending, they should consider the following firm characteristics: (1) a firm’s growth opportunities; (2) a firm’s financial leverage; and (3) the CEO’s stock ownership prior to stock option grants. This paper addresses the effectiveness of CEO stock option granting decisions by examining whether compensation committees take these three factors into account. Using a recent sample over the period of 1992-2006, we find that firms with greater growth opportunities and firms in lower financial leverage are more likely to award CEO stock options to motivate R&D investment. These findings are consistent with that options are designed effectively to motivate managerial risk taking, thereby aligning the interests of managers with those of shareholders. However, contrary to our prediction, compensation committees tend to grant more to CEOs with larger stock ownership to induce R&D spending. A potential explanation for this finding is that CEOs with relatively large stock ownership affect the granting process and grant themselves with excessive stock options. Taken together, the evidence of CEO stock option granting process partially supports the notion that firms make effective stock option plans to mitigate incentive problems of risk-averse managers.

The Value-Relevance Of Stock-Based Employee Compensation Disclosures

<p class="MsoNormal" style="text-align: justify; margin: 0in 37.8pt 0pt 0.5in;"><span style="mso-bidi-font-style: italic;"><span style="font-size: x-small;"><span style="font-family: Batang;">This study employs pro-forma company footnote disclosures to assess the value-relevance of employee stock option compensation expense using the fair value method as stipulated by Statement of Financial Accounting Standard No. 123.<span style="mso-spacerun: yes;">  </span>The study is motivated by the controversy surrounding the issue of accounting for employee stock options and the countervailing effects of issuing stock options on firm value.<span style="mso-spacerun: yes;">  </span>Although accounting regulators and the business community agree that employee stock options have value and therefore, are a form of compensation, critics of the FASB’s proposed fair value method of accounting for employee stock options argue that measuring the compensation expense using contemporary models will result in unreliable and meaningless measures.<span style="mso-spacerun: yes;">  </span>Moreover, the expected future benefits from granting stock options suggest that this form of employee compensation is not a typical expense.<span style="mso-spacerun: yes;">  </span>We find a significant association between the disclosed compensation expense using the fair value method and firm value that is in the opposite direction from other income statement expenses.<span style="mso-spacerun: yes;">  </span>This result implies that the disclosed employee stock option expense is a value-relevant measure and the incentives derived from employee stock option plans provide value-increasing benefits to the firm.<span style="mso-spacerun: yes;">  </span>In addition, we find the positive association between the employee stock option expense and firm value is greater for firms with more growth opportunities.</span></span></span></p>

Legal and accounting issues of manipulating the timing of stock option grants

PurposeMany corporate managers, with the aid of the board of directors, discovered that they could provide themselves with guaranteed or excessive compensation by manipulating the terms of stock option grants that were included in their compensation packages. This paper seeks to examine the legal, tax, and accounting issues that have evolved because of these suspect illegal activities.Design/methodology/approachThe author presents the theory behind performance‐based compensation that is the basis for employee stock option grants. The author then examines regulations, judicial theory, and court cases to determine the current legal status of backdating, spring loading, or bullet dodging of executive stock option grants.FindingsThe current legal environment has made it difficult for executives to continue the practice of manipulating stock option grants without falling under the ire of regulators and shareholders. However, a question remains whether executives that manipulated stock option grants in the past will be found criminally liable for their acts.Practical implicationsThe paper's review of the discourse on the legality of corporate executives enhancing their compensation packages shows the complexity of detecting and regulating this type of suspect activity.Originality/valueThis paper presents a contemporaneous discussion and data on legal and regulatory changes that resulted from management malfeasance of executive compensation.

Stock Option Use by Australian IPOs

This paper examines the use of stock options by Australian IPOs. Stock options in this setting exhibit heterogeneity of ‘in the moneyness’ attributes. We can therefore identify incentive ‘out of the money’ options and reward ‘at or in the money’ options and study their usage. The setting also features options granted to employees (CEO, executives, non-executive directors, and managers) and external parties (e.g., underwriters, lenders, seed capitalists, and promoters). We examine the motives for granting stock options with different ‘in the moneyness’ attributes to employees and external parties, as well as the performance outcomes. Our results suggest ‘in the moneyness’ attributes of options vary according to uncertainties about growth options, general operating risks, and/or agency risks relating to the use of IPO proceeds; however, these relations do not translate into robust links from the option grants to future performance.

Backdated Stock Options Ownership Impact On The Corporation, Management, & Shareholders

In the post-Sarbanes-Oxley Act (SOx) world, there has been an unprecedented crackdown on fraudulent activity occurring within corporate America. During recent years, many companies have granted stock options to their executives and employees as part of compensation packages. While the issuance of stock options as a component of compensation is considered to be a legal practice, corruption has taken this corporate resource to unlawful heights. Recently, numerous corporations have been in the news for potentially backdating stock options. Accordingly, the purpose of this paper is to distinguish between legal and illegal aspects of backdating stock options, and to examine the ethics of such corporate activity.

Incentivizing managers to build innovative firms

We investigate whether the equity-linked components of top executive pay have an effect on patenting activity within a firm. We find a positive relationship between firm patenting activity and managerial alignment incentives created by stock and stock option grants. Prior work has shown that the market value of a firm reflects the value of its patents. Thus, our finding suggests innovation is one such channel through which equity alignment incentives positively impact firm value. On the other hand, we find that the risk-taking incentive from stock options does not increase patenting.

Incentivizing Managers to Build Innovative Firms

We investigate whether the equity-linked components of top executive pay have an effect on patenting activity within a firm. We find a positive relationship between firm patenting activity and managerial alignment incentives created by stock and stock option grants. Prior work has shown that the market value of a firm reflects the value of its patents. Thus, our finding suggests innovation is one such channel through which equity alignment incentives positively impact firm value. On the other hand, we find that the risk-taking incentive from stock options does not increase patenting.

The Impact of IFRS 2 "Share-Based Payment" on Malaysian Companies

In the wake of corporate scandals and excessive stock options compensation, International Accounting Standard Board (IASB) has introduced a new accounting standard, IIFRS 2 Share-based Payments. The scope of the standard extends beyond payments to employees, but for the purpose of this study, the focus is only on 'employee stock options'. IIFRS 2 requires a fair value of stock options records calculated on grant date, and recognized as compensation expenses over vesting periods. Prior to the introduction of IIFRS 2, stock options were not recognized and were only disclosed in the notes to the accounts. In Malaysia, the standard is mandatory for all companies listed on or after January 1, 2006. This study assumes the requirement existed in 2003. This study examines the impact of stock options expenses from 2003 to 2005, on the top 100 Malaysian companies. The three year observations show at least 24% of the sample exceeds the 5% materiality threshold on diluted EPS. The sectors that are impacted the most are the Trade/Service and Finance sectors. From the multiple-regression test, this study finds that fair value of stock options have a negative relationship with dividend yields (input of the Black-Scholes Merton (BSM) Model). Most companies in the sample are found to pay dividends and grant stock options at the same time. Therefore, this study suggests that companies need to restructure their compensation plan thus balancing the stock options granted and dividends paid in the future.

Cashing In on Managerial Malfeasance: A Trading Strategy around Forecasted Executive Stock Option Grants

This study examined the profitability of a trading strategy that exploits the manipulation of stock prices around the grant date of executive stock options. The strategy generates annualized abnormal returns of 1.4–5.2 percent net of transaction costs and is relatively unaffected by the Sarbanes–Oxley Act of 2002.

Determinants of CEO Pay: A Comparison of ExecuComp and Non-ExecuComp Firms

ABSTRACT: We document that firms included in the ExecuComp database tend to be larger, more complex, followed by more analysts, have greater stock liquidity levels, and have higher total, but less concentrated, institutional ownership than other firms. Based on these differences, we test and find support for three predictions. First, ExecuComp firms rely more heavily on earnings and stock returns in determining CEO cash compensation. Second, the weight on earnings is more sensitive to differences in the extent of growth opportunities for ExecuComp firms. Third, the positive relation between institutional ownership concentration and the value of stock option grants is stronger for ExecuComp firms. Overall, our results suggest that ExecuComp and non-ExecuComp firms operate in different contracting environments that lead to differences in the design of their executive compensation contracts. As a result, care should be taken in extending results based on ExecuComp samples to non-ExecuComp firms.

Real Option Financing Under Asymmetric Information

I study the impact of capital market imperfections on the exercise of a real option. An entrepreneur has private information about a venture for which she seeks outside funding. An initial investment gives access to a continuous flow of information about the project. The duration of that experimentation phase is used to signal quality and investment may be delayed relative to the first best. Investors use milestone contracts, and the entrepreneur is granted stock options with a vesting period or receives a compensation in case of failure. The pay-performance sensitivity of her compensation is correlated with risk taking. The initial mix of inside and outside financing affects the timing of future investment, in line with empirical evidence.