In this paper, we assess whether the firm‘s Black Scholes‘ value of stock options granted to the top five executives is associated with benefits in the form of increased future operating earnings. Although stock options comprise the fastest growing component of top management compensation, there is no consensus on the relation between employee stock option compensation and future firm performance. This lack of consensus can be distilled into two opposing perspectives.
The optimal contracting perspective argued by a number of financial economists states that options are granted optimally to reduce the moral hazard problem that arises because senior managers often own very little of the firms they manage. A substantial body of theoretical work beginning with Jensen and Meckling (1976) suggests that option contracts can align managers‘ incentives with that of shareholders. Consistent with this perspective, some researchers (e.g., Demsetz and Lehn 1985; Himmelberg, Hubbard and Palia 1999; Core and Guay 1999; Rajgopal and Shevlin 2002) predicate their analyses on the premise that granting options is consistent with firm value maximization.
A second perspective, popular among shareholder rights activists and organized labor, is that senior managers have taken control of the pay-setting process and compensate themselves in excess of the level optimal for shareholders (we label this view as the rent extraction perspective). Some have claimed that stock options do not exhibit empirical relations consistent with the economic motivations behind granting them (e.g., Yermack 1995) and may even be a politically expedient way of paying senior managers as such compensation is off the balance sheet (e.g., Crystal 1991). Others have presented evidence that managers abuse option grants for their own selfish ends (e.g., Yermack 1997; Aboody and Kasznik 1999; Bens, Nagar and Wong 2001; Carpenter and Remmers 2001).
We estimate whether a firm‘s Black-Scholes value of new executive stock options granted to its top five executives is associated with future operating earnings to examine these conflicting perspectives. In the baseline regressions covering 2,627 firm-year observations from years 1998-2000 and ESO grants from 1993-2000, we find that a dollar of the Black-Scholes value of an option grant to the top five executives of a firm is associated with a decrease in future operating income (undiscounted) over the next five years of $1.58.
To understand the genesis of this negative payoff, we examine the association between option grant value and two sets of factors: (i) exogenous economic factors that might influence firms to give options such as cash and dividend constraints or growth opportunities, and; (ii) proxies for corporate governance such as the extent of power between the shareholders and managers, the relation between CEO and the board of directors and the number of board meetings. We find ESO grant values are related to several hypothesized economic determinants. However, the proxies for corporate governance quality are generally not significant in the direction predicted by rent extraction, providing little support for the rent extraction hypothesis.
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Are Executive Stock Options a Positive NPV Investment for the Firm?
