Employee Stock Options, Financing Constraints, and Real Investment: Theory and Evidence

In this paper, we demonstrate the advantage of the use of broad-based stock option plans over cash compensation when the …rm needs to …nance both current and future investment in an environment where external …nance is costly. Intuitively, the company obtains funds for investment in the current period by cutting …xed wages through the issuance of stock options. The company receives additional funds in later periods when it collects the cash proceeds and tax savings from option exercises. Importantly, the cash in‡ow arising from option exercises is correlated with improvements in the …rm’s investment opportunities, thus providing funds in precisely those states of the world where the demand for investment is high. Option grants in the current period therefore allow the …rm to relax both its current and future …nancing constraints and to increase investment in positive NPV projects. Consistent with the predictions of the model, we estimate that …rms increase investment by $0.38 for each dollar of proceeds received from the exercise of stock options, and that the sensitivity of investment to proceeds from option exercises is higher in …rms likely to face …nancing constraints. Babenko is with the Department of Finance, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong, [email protected]. Tel. +852-23587679. Lemmon is with the University of Utah, Eccles School of Business, …[email protected], Tel (801) 585-5210. Tserlukevich is with the Department of Finance, Hong Kong University of Science and Technology, [email protected], Tel. +852-23588016.