Firms regularly grant stock and stock options to their employees as a way to align the incentives of employees and shareholders. This is particularly relevant for executives, because they routinely make decisions that have an appreciable effect on firm value and their incentives often clash with those of shareholders. It is unclear, however, whether the alignment motivation is relevant for rank-and-file (R&F) employees, because their individual behavior in the workplace has a trivial effect on firm value.

An alternative motivation for awarding stock options is to reduce employee turnover. All firms incur costs from recruiting and training replacement employees, including productivity lost until the new employees are fully trained. Furthermore, firms with proprietary intellectual capital suffer when departing employees transfer that capital to rival firms.

Stock option grants might reduce turnover for a couple of reasons. First, they are effectively deferred payments, such that employees who leave might forego substantial value, either because they exercise the options early, thereby giving up time value, or forfeit unvested options, thereby giving up their entire value. Second, the value of the stock, and, thus, the value of stock options, increases as the industry in which the firm operates performs better, and, thus, the outside employment opportunities are enhanced. Consequently, the use of stock options helps firms retain employees when they otherwise would be tempted to leave.

We examine firms’ motivation to grant stock options to their employees in an effort to limit the transfer of intellectual capital to rival firms. Our empirical setting is based on state courts’ adoption of the so-called Inevitable Disclosure Doctrine (IDD). The IDD justifies preventing a firm’s former employees from working for a rival firm if the new employment would inevitably lead the employees to disclose the firm’s trade secrets and cause the firm irreparable harm. Thus, IDD adoptions can be viewed as negative exogenous shock to the risk that employees transfer intellectual capital to rivals. This leads to our hypothesis that a state’s adoption of the IDD causes firms in the state to reduce stock option grants to their employees. The staggered adoptions by various states facilitate a powerful difference-in-difference (DID) test for our hypothesis.

Our sample spans the period between 1992 and 2005. We focus on two employee groups: the five best paid executives and R&F employees. For the former group we examine the effect on stock option grants, stock grants, and other types of compensation, while for the latter group we only examine the effect on stock option grants due to limited data.

In our initial analysis, we regress stock option grants and other types of compensation against an IDD adoption indicator variable that equals one if the firm is in a state that has adopted the IDD. The results show that the IDD adoption has a negative and statistically significant effect on stock option grants for both executives and R&F employees. In addition, the IDD adoption has a negative and marginally statistically-significant effect on payouts to executives under long-term incentive plans (LTIPs). We further partition the IDD adoption indicator variable into multiple indicator variables based on the number of years since the states in which the firms are located adopted the IDD. The results show that the effect of the IDD adoption on option grants first occurs in the adoption year and persists the year thereafter. We interpret our results as evidence that the IDD adoption has a causal effect on option grants to executives and R&F employees, consistent with our hypothesis.

Next, we explore cross-sectional variations in the effect of the IDD adoption. First, we conjecture that the effect is more pronounced among firms with high R&D. High R&D firms have more intellectual capital, thus suffering more if their employees transfer to rival firms and bring along part of the intellectual capital. The results show that the negative effect of the IDD adoption on option grants is indeed more pronounced for firms with high R&D, and this holds for grants to both executives and R&F employees. Among firms with high R&D, the IDD also has a negative effect on long-term incentive payouts to executives.

Second, we conjecture that the effect is stronger among firms with nearby rivals. The costs of moving and information asymmetries between employers and employees might give rise to geographically segmented labor markets, such that employees are more likely to shift employment to rival firms that are geographically proximate. If firms’ decision-makers presume their employees to be geographically constrained, they should be more aggressive in counteracting employee turnover when rivals lurk in the same region. Consistent with our conjecture, the results show that the negative effects of the IDD on option grants to R&F employees and the long-term incentive pay of executives intensify with proximity to rivals.

During our sample period, three states (Florida, Michigan, and Texas) rejected the IDD they had previously adopted. This allows us to test whether the earlier effects revert. Despite a smaller set of events, we report that the IDD rejections indeed have the opposite effects of IDD adoptions. That is, the IDD rejections cause affected firms to increase option grants to R&F employees and both option grants and long-term incentive payouts to executives. Furthermore, all three effects are stronger among firms with nearby rivals, and the effect on executive stock option grants is also stronger among firms with high R&D. The opposite effects across negative and positive shocks in employee turnover risk (i.e., IDD adoptions and rejections) provide assurance that our results are not spurious.

Overall, we offer strong evidence that firms actively grant options to retain executives and R&F employees. But our evidence also shows that the inclination to use options is more prominent among firms with employees who are at high risk of transferring proprietary intellectual capital to nearby rivals, which suggests that firms deploy option grants to patch the leak of intellectual capital. Furthermore, our evidence reveals that decision-makers of option grants, i.e., board members and executives, view the labor markets to be geographically segmented for both executives and R&F employees, which has implications for how we should view executive turnover, hiring, and compensation.

This post comes to us from professors Erik Lie at the University of Iowa and Tingting Que at the University of Alabama in Huntsville. It is based on their recent article, “On the Use of Option Grants as a Retention Tool,” available here.