Neighborhood Matters: The Impact of Location on Broad Based Stock Option Plans - Harvard Law School Blog - 8/22/08

(Editor’s Note: This post comes from Simi Kedia at Rutgers Business School and Shivaram Rajgopal at the University of Washington Michael G. Foster School of Business)

Our forthcoming paper in the Journal of Financial Economics, Neighborhood Matters: The Impact of Location on Broad Based Stock Option Plans,
provides the first evidence on the importance of geographic effects on
broad based stock option plans. The question of why broad based option
plans are so prevalent in the real world remains a puzzle for standard
economic theory. Broad based options are a costly form of compensation
relative to other alternatives, such as cash, because: (i) employees
can expect to only garner trivial personal gains from their
contribution to firm value or profits; and (ii) holding stock options
in their employer exposes employees to stock price risk which is highly
correlated with the risk in their human capital. Yet, broad based
equity plans are commonly observed in corporate America. We show that
the geographically segmented labor markets for rank and file talent is
a hitherto unexplored explanation for why we observe broad-based option
plans.

Using data on rank and file option grants from over 9,000 firm-years
from Execucomp over the years 1992-2004 intersected with geographical
data gathered from several sources such as the U.S. Census Bureau, we
find that firms grant more options to rank and file workers when a
higher fraction of firms in the local community (firms located within a
100 or a 250 km of its headquarters) grant more broad based options.
This result holds regardless of whether we analyze aggregate
state-level, or county-level, or individual firm-level patterns in
broad-based option usage. We recognize that firms of certain industries
cluster in certain geographical areas. However, the effect of the local
community’s option usage on an individual firm’s holds even after
controlling for industry membership and other traditional variables
known to account for broad based option usage such as firm size,
investment opportunity, leverage, cash constraints of the firm, its tax
status and its stock return performance.

The neighborhood’s option granting practices can affect an
individual firm’s option usage for two reasons: (i) influence through
the labor market circumscribed by firm’s geographical neighborhood; and
(ii) influence of other exemplary peer firms in the neighborhood. Our
empirical results find consistent and strong support for the role of
tight labor markets in an individual firm’s option granting decisions.
In particular, we find that the neighborhood’s option granting affects
an individual firm’s option grants when (i) the neighborhood has more
rather than fewer firms, a proxy for the demand of rank and file labor;
and (ii) the firm has a higher local beta. Further, the effect of a
firm’s local beta on its broad based options usage is statistically
significant only when the firm faces a tight labor market in its
neighborhood. There is some empirical support for the peer-influence
story in that the neighborhood’s option granting practices matter to an
individual firm’s option granting when exemplar firms are present in
its neighborhood. However, this result is not robust to the
introduction of proxies for tight labor markets, suggesting, in effect,
that tight labor markets, in general, and Oyer’s (2004) wage indexation
explanation in the presence of tight labor markets, in particular, are
the key reasons why the community’s broad based option grants explain
option usage for individual firms.

The full paper is available for download here.