Taxation and executive compensation: Evidence from stock options

Understanding the effects of taxes on executive compensation provides insight into the process determining this compensation and is a key input to top income tax rate policy. A 2010 tax reform in Canada, which greatly increased the effective tax rate on stock option compensation for a subset of firms, provides a natural experiment with which to address this issue. Difference-in-differences estimates suggest that this tax increase resulted in an immediate reduction in both stock option grants and the fraction of total compensation made up of stock options with limited, if any, substitution towards other components of compensation.     

Should there exist secondary markets for executive stock options?

This paper investigates the potential disadvantages of the secondary markets for executive stock options (ESOs). The benefits of such markets are evident, but they might also have negative effects for shareholders. Executives might, for example, use inside information to time their ESO selling. We investigate two personal motives of managers that can be assumed to affect their optimal selling decision, that is, managers' personal portfolio management issues and the use of inside information. We explore these motives by analyzing unique data from Finland, where there are secondary markets for ESOs. The results of the study support the traditional portfolio diversification hypothesis according to which managers tend to sell their ESOs when holding an ESO is equivalent to holding the underlying stock; that is, in such a case a manager's wealth is closely tied to the stock price of the firm. With respect to the use of inside information the results indicate that ESO selling activity is not related to future stock price behaviour, suggesting that managers do not use inside information to determine the selling time of their ESOs. These results imply that the existence of secondary markets for ESOs does not weaken the usefulness of ESOs as the management compensation, although the benefits of such markets are evident.     

Maturity and exercise price of executive stock options

Using a simple three-period model in which a manager can gather information before making an investment decision, this paper studies optimal contracts with various stock options. In particular, we show how the exercise price of executive stock options is related to a base salary, the size of the option grant, leverage, and the riskiness of a desired investment policy. The optimal exercise price increases in the size of grant and the base salary and decreases in leverage and the riskiness of a desired investment policy. Other things equal, the optimal exercise price of European options with a longer maturity should increase more for an increase in the base salary and the size of grant and decrease more for an increase in leverage than the one with a shorter maturity. The optimal exercise price of American options is determined by the optimal exercise prices of European options with different maturities. Given the fixed exercise price, the size of the option grant does not decrease in the face value of debt.     

Leverage, volatility and executive stock options

This paper studies how an optimal wage contract can be implemented using stock options, and derives the properties of the optimal contract with stock options. Specifically, we show how the exercise price and the size of the option grant should change in response to changes in exogenous parameters. First, for a fixed exercise price of executive stock options, the size of the option grant decreases in the riskiness of a desired investment policy, decreases in the volatility of return from the risky project, and increases in leverage. Second, for a fixed size of the option grant, the optimal exercise price of managerial stock options increases in the riskiness of a desired investment policy, increases in the volatility of return from the risky project, and decreases in leverage. Several empirical predictions are drawn from these conclusions regarding the pay-performance sensitivity of management compensation.     

Are share price levels informative? Evidence from the ownership, pricing, turnover and performance of IPO firms

We ask whether a firm's choice of IPO price is informative in the sense that it relates systematically to the firm's other choices and characteristics. We find that both institutional ownership and underwriter reputation increases monotonically with the chosen IPO price level. We also find that the relationship between IPO price and underpricing is U-shaped. In contrast, post-IPO turnover displays an inverted U-shaped relation to IPO price. Moreover, firms choosing a higher (lower) stock price level experience lower (higher) mortality rates. Our results are robust to controls for market liquidity and firm size, and for partial adjustment of IPO prices based on pre-market information.     

Valuing executive stock options: performance hurdles, early exercise and stochastic volatility

Accounting standards require companies to assess the fair value of any stock options granted to executives and employees. We develop a model for accurately valuing executive and employee stock options, focusing on performance hurdles, early exercise and uncertain volatility. We apply the model in two case studies and show that properly computed fair values can be significantly lower than traditional Black–Scholes values. We then explore the implications for pay-for-performance sensitivity and the design of effective share-based incentive schemes. We find that performance hurdles can require a much greater fraction of total compensation to be a fixed salary, if pre-existing incentive levels are to be maintained.     

Valuation and incentive effects of hurdle rate executive stock options

Traditional executive stock options are often criticized for inherently weak links between pay and performance. Hurdle rate executive stock options represent a viable improvement. However, valuing these options presents extraordinary analytic difficulties. With a constant dividend yield the strike price becomes a path-dependent function of the stock price and exact analytic valuation is intractable. To solve this problem, we apply the Monte Carlo valuation approach developed by Longstaff and Schwartz (Rev Financ Stud 4:113–147, 2001) to estimate the value of path-dependent American options. We also extend the methodology to incorporate the theoretical framework by Ingersoll (J Bus 79:453–487, 2006) to permit subjective valuation influenced by an executive’s risk aversion.

Risk-taking incentives of executive stock options and the asset substitution problem

Various theoretical models show that managerial compensation schemes can reduce the distortionary effects of financial leverage. There is mixed evidence as to whether highly levered firms offer less stock‐based compensation, a common prediction of such models. Both the theoretical and empirical research, however, have overlooked the leverage provided by executive stock options. In principle, adjusting the exercise prices of executive stock options can mitigate the risk incentive effects of financial leverage. We show that the near‐universal practice of setting option exercise prices near the prevailing stock price at the date of grant effectively undoes most of the effects of financial leverage. In a large cross‐sectional sample of Canadian option‐granting firms, we find evidence that executives' incentives to take equity risk are negatively rather than positively related to the leverage of their employers.     

What determines early exercise of employee stock options in Australia?

Employee stock options (ESOs) are a popular way of remunerating employees. We analyse factors at the firm and option level affecting the employee's decision to exercise ESOs before they mature. Exercises over the period 1998–2004 are analysed and the key factor influencing early exercise is found to be dividends. Exercises frequently occur well before maturity, but in most cases little time value is sacrificed. Our findings have implications for the ‘fair’ valuation of ESOs in companies’ financial statements, as required by the relevant Australian accounting standard, AASB 2.     

An investigation of the short-term performance of the Canadian IPO market.

This article explores the short-term return performance of the Canadian initial public offering (IPO) market. Historically, the Canadian IPO market has shown to be one of the least underpriced markets in the world. This paper uses recent IPOs from 2010 to 2017, and the results confirm that the Canadian IPO market remains one of the least underpriced IPO markets in the world. The mean (median) first-day returns show that Canadian IPOs are marginally underpricing at only 1.45% (0.24%) during the sample period. Additional short-run return measures indicate that Canadian IPOs underperform the market in their 1-month, 6-month, and 12-month holding periods. This research also contributes to the existing IPO literature by showing that restricted voting share offerings tend to be more underpriced and perform poorly over the short-term.