Neighborhood Matters: The Impact of Location on Broad Based Stock Option Plans

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.

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