Repurchases, Employee Stock Option Grants, and Hedging

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Repurchases, Employee Stock Option Grants, and
Hedging

• Daniel A. Rogers
• Portland State University

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Elevator pitch

• Whats the rationale for observed relation
  between employee options and stock repurchases?
• Partial explanation repurchases serve as hedge
  against uncertainty surrounding option
  obligations.
• Provides more economic justification than EPS
  management hypothesis.
• Findings
• Employee stock option grants exhibit positive
  relation with repurchases.
• For firms in which this relation is strongest, I
  find evidence consistent with an optimal hedging
  motive (although there might be more to the
  story?.

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Background on options and repurchases

• Microsoft We repurchase our common shares
  primarily to manage the dilutive effects of our
  stock option and stock purchase plans, and other
  issuances of common shares. - 2003 10-K Footnote
  14 to financial statements.
• Existing empirical evidence
• Substitution of repurchases vs. dividends (exec
  story) Fenn and Liang (2001 JFE) and Kahle (2002
  JFE).
• Option funding Kahle (2002 JFE).
• Earnings management (anti-dilution) Bens et al.
  (2003 JAE) and Weisbenner (2000 wp).

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Another Story?

• Granting options to employees creates uncertain
  future liability for shareholders.
• Current shareholders incur an opportunity cost
  when employee stock options are exercised.
• Amount of the opportunity cost (stock price at
  exercise date exercise price).
• Do shareholders hedge this uncertainty?
• Hedging strategy repurchase shares when options
  are granted.
• Similar to a forward purchase of currency or
  commodity.
• Strategy implies positive relation between
  repurchases and option grants over time.

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Example

• Assume
• Stock price 20 Option granted at the money
  Cost of equity 8 and Dividend yield 3
• What is the ultimate cost borne by existing
  shareholders?
• Exercise price at time of exercise grant date
  price
• Suppose exercise occurs in 5 years FV of 20
  invested in 5 years 25.68 (20 1.055)
• Ex post economic cost 5.68 if repurchase
  (known at time of grant and repurchase)
• Ex post economic cost ??? if no repurchase

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How does situation differ from other hedging
problems?

• Typical hedging situation bad outcomes low
  cash flows or earnings.
• In this case bad outcome is high stock price
  at time of exercise.
• Normal opportunity cost stock price increases
  by dividend-adjusted cost of equity.
• If stock price change between grant and exercise
  dates exceeds dividend-adjusted cost of equity,
  repurchasing stock at grant date provides a
  positive payoff against excess opportunity cost.

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Why might a high stock price be bad?

• Jensen (2005) arguments
• Management games market expectations ? stock
  price gt intrinsic value
• Wealth-destroying acquisitions (Moeller et al.,
  2005 JF)
• Employees choose when to exercise If employees
  exercise options when price is above intrinsic
  value ? rent extraction.
• If company repurchases stock at high prices, its
  alternatives to fund growth opportunities are 1)
  less investment, 2) tap external capital markets

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What are the traditional incentives to hedge?

• Reduction of underinvestment/distress costs
• Froot et al. (1993), Tufano (1998), Smith and
  Stulz (1985), among others.
• Tax function convexity
• Smith and Stulz (1985)
• Increase borrowing capacity and interest tax
  shields
• Leland (1998)
• Managerial motives
• Smith and Stulz (1985), Stulz (1984), Tufano
  (1996), among others.

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Does the option hedging story fit into any of
these categories?

• Reduction of distress and tax convexity?
• Clearly, NO!
• Increasing debt tax shields?
• Maybe
• Mozes and Raymar (2001 wp) issue options, issue
  debt and repurchase stock.
• Managerial motives?
• Hard to disentangle hedging motive from
  underpriced stock story.

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What about the underinvestment theory?

• If assume firm monetizes opportunity cost by
  repurchasing shares around option exercise, then
• Higher stock price ? less cash available for
  investment at exercise date.
• If deadweight costs associated with new (debt)
  financing, then firm might underinvest.
• Repurchasing stock at grant date is effective if
  investment opportunities are correlated with
  stock price (this idea seems reasonable).

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Plan of attack

• First, establish if a link exists between option
  grants and stock repurchases.
• Regress stock repurchases on option grants and
  other explanatory variables.
• If a link exists, then can optimal hedging story
  explain hedging behavior?
• Construct a measure of hedging and regress
  optimal hedging proxy variables against it.

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Sample

• 151 randomly selected SP 500 firms.
• Manual data collection of employee option data.
• Time frame 1993 2003 (or maximum 10-K filings
  available from EDGAR).

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Research design - Option grants repurchases

• Dependent variable number of shares repurchased
• Independent variables
• log of market capitalization
• free cash flow
• market-to-book of assets
• capital expenditures
• long-term debt
• dividend yield
• stock price change
• stock price volatility
• option grants ? this is the variable of interest!
• exercised options

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Data summary
Mean Median Std Dev
Repurchases 1.83 0.69 2.83
Option grants 2.23 1.56 2.91
Rep / grants 2.42 0.36 18.87
Exercises 1.08 0.70 1.37
Total options 8.10 6.93 6.84
Vested options 4.06 3.39 3.34
Exec options 1.65 1.24 1.79
Vested exec options 0.90 0.60 1.08

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Methodological issues

• Dependent variable is censored at zero
  (approximately 1/3 of observations)
• Suggests Tobit methodology
• Panel data
• Random/fixed effects
• Fixed effects model in Tobit would yield biased
  estimates.
• Tobit random effects estimation

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Key results Base repurchases model (Table 2)

• Repurchases and options
• Positive relation with option grants and
  exercises.
• Robust to inclusion of other option variables
  (Panel B).
• Other option variables do not exhibit similar
  statistical relations with repurchases (Panel B).
• Repurchases and other variables
• Positive relations with
• Firm size, and free cash flow.
• Negative relations with
• Market-to-book, leverage, current year stock
  price change and volatility.

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Robustness results Table 3

• Excess grants are positively related to
  repurchases (two-stage model).
• Controlling for lagged option grants back 4
  years.
• Concurrent grants remain positively related to
  repurchases.
• Evidence of stronger relations for 1 and 2-year
  lagged grants.
• Controlling for Bens et al. (2003) earnings
  management variables.
• Option grants remain positively related to
  repurchases.

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How Is Hedging Defined?

• Cannot directly observe hedging from
  disclosures.
• Derived measure
• Coefficient of variation for repurchases-to-grants
  ratio inverse hedging measure.
• Effectively captures a population driving
  positive relation between grants and repurchases
  in multivariate.

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Coefficient of variation and mean
Repurchases-to-grants ratio
Full sample 140 firms (at least 1 yr of repurchases) Full sample 140 firms (at least 1 yr of repurchases)
Coefficient of variation Mean
Average 1.58 2.64
Median 1.40 1.13
Standard deviation 0.73 6.17
25th percentile 1.02 0.50
75th percentile 2.05 2.38
Minimum 0.24 0.01
Maximum 3.32 57.67

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What variables explain option grant hedging?

• Table 5 differences between models
• Model 1 no industry controls
• Model 2 industry controls, but no control for
  variation of repurchases-to-exercises
• Model 3 includes variation of repurchases-to-exer
  cises, but no industry controls
• Model 4 Controls for variation of
  repurchases-to-exercises and industry effects
• Model 4 results - Effect on hedging
• Leverage Negative relation
• RD expenditures Positive relation
• Vested exec options Positive relation
• Firm size Negative relation
• Market-to-book Negative relation
• Exec shares held Positive relation

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What about the non-hedgers?

• Table 6 results
• Difference between non-repurchasing firms vs.
  those that repurchase (logit)
• Lower free cash flow
• Greater leverage
• More RD
• Continuous measure of option grant hedging
• Very similar results relative to Table 5

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Summary of Most Notable Results

• Option grants are positively related to
  repurchase activity.
• Even if not intentional, this pattern provides a
  hedge for shareholders against uncertain
  opportunity cost of options.
• Firms that exhibit less variation in repurchase
  activity relative to option grants also exhibit
  greater RD spending and less leverage.
• This set of results fits underinvestment costs
  rationale for hedging.