Share Repurchases and Employee Compensation

This paper focuses on the agency problem derived from the con‡ict of interest between employees and shareholders. I show that if employees are compensated with restricted stock or stock options, shareholders may engage in opportunistic share repurchases. Equityholders have an incentive to buy back stock after employment contracts have been signed because repurchases increase compensation sensitivity to …rm cash ‡ows and create stronger incentives for …rm employees and executives. When …rm cash ‡ows are uncertain, this generates agency costs due to suboptimal risk sharing and external …nancing costs. I provide new empirical implications and test them using data on announcements of 1,295 open-market share repurchases during 1996-2002. Consistent with the incentive e¤ect of stock buybacks, I …nd that the market reacts more favorably to repurchase announcements when the …rm has many outstanding and few currently exercisable employee stock options, and when management holds a large stake in the …rm. In addition, after repurchases, employees and executives receive fewer stock option grants and decrease their risk exposure by exercising more stock options. Haas School of Business, Berkeley, CA 94720-1900, Email: [email protected], Tel. 510-525-7030 yThis paper has bene…ted from insightful comments by Chris Hennessy, Je¤rey LaFrance, Nicole Johnson, Alexandre Mas, John Morgan, Jacob Sagi, Yuliy Sannikov, Mark Seasholes, and Nancy Wallace. I am especially grateful to Hayne Leland for his advice. All errors are mine alone. I thank Sandra Rodgers for excellent research assistance. IBER support is gratefully acknowledged.