Taking Stock: Equity-Based Compensation and the Evolution of Managerial Ownership

We investigate the impact of stock-based compensation on managerial ownership. We find that equity compensation succeeds in increasing incentives of lowerownership managers, but higher-ownership managers negate much of its impact by selling previously owned shares. When executives exercise options to acquire stock, nearly all of the shares are sold. Our results illuminate dynamic aspects of managerial ownership arising from divergent goals of boards of directors, who use equity compensation for incentives, and managers, who respond by selling shares for diversification. The findings cast doubt on the frequent and important theoretical assumption that managers cannot hedge the risks of these awards. WE INVESTIGATE THE IMPACT OF STOCK-BASED COMPENSATION, including options and restricted stock, on the ownership of U.S. executives. Equity-based pay spread at explosive rates in the United States during the 1990s. Morgenson ~1998! reports that in 1997, the 200 largest U.S. companies had reserved more than 13 percent of their common shares for compensation awards to managers, up from less than seven percent eight years earlier. Institutional investors and shareholder activists have tolerated and even encouraged this diversion of equity to executives, believing that managerial ownership may reduce agency problems. Boards’ compensation committees routinely cite the goal of increasing managerial ownership as the rationale for equity-based pay.1 Although boards state that they intend stock options and other awards to boost the ownership of managers, executives are not likely to have the same goal. Modern portfolio theory predicts that managers receiving additional stock in their firms should sell these shares or, equivalently, sell other shares * The authors are from New York University. We appreciate helpful comments and assistance from Michael Lemmon, Henri Servaes, Abbie Smith, René Stulz, Robert Whitelaw, Marc Zenner, an anonymous referee, and seminar participants at the American Compensation Association academic research conference, the American Finance Association annual meetings, Case Western Reserve University, the University of Chicago, the London Business School, the University of North Carolina, the University of Pennsylvania, Purdue University, Rice University, the University of Virginia, and Virginia Polytechnic Institute. For representative examples from well-known firms, see the proxy statements filed by Minnesota Mining and Manufacturing Co. in 1997, which state that “the company’s stock option plan . . . is designed to increase ownership of the company’s stock,” and by Procter & Gamble Co. in 1995, in which the firm’s description of its compensation policy refers to “the company’s desire to increase management’s stock ownership.” THE JOURNAL OF FINANCE • VOL. LV, NO. 3 • JUNE 2000