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Stock options are often used as part of a compensation package offered to the employees of a firm. The use of stock options as part of compensation is usually justified on the basis of providing incentives to employees in terms of increased compensation when shareholder wealth grows (i.e., the stock price increases). In this way, employees are enticed to act in the interests of owners to increase the value of the firm since their own wealth increases at the same time.

This motivation for options requires some degree of control on the part of an employee in terms of influencing the stock's price. However, non-executive employees often do not have the ability to influence the stock price to any significant degree. Thus, explaining the issuance of options to non-executives is problematic for the incentive hypothesis.

Many other hypotheses have been offered to explain the extensive use of options in compensation agreements. One hypothesis, a financing (or what Yermack [1995] refers to as a "liquidity") explanation, has received particularly little rigorous investigation. In this paper, we offer a model for the use of options based on a financing explanation that is consistent with the broad use of options in compensation beyond top executives.

Our model identifies an optimal use of options in compensation as the point in which the marginal benefit of using options for financing equals the marginal cost from the discount an employee places on "risky" options. Our model also incorporates the ability of employees to invest a portion of their wealth in a market portfolio in order to provide some diversification. We show that a financing motivation can indeed explain the broad use of options to compensate non-executive employees. For example, our simulation results indicate that the optimal use of options is 9.3% of compensation for an employee with a compensation of $50,000.

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PDF Ebook Employee Stock Options in Compensation Agreements: A Financing Explanation