Share Repurchases and Pay-Performance Sensitivity of Employee Compensation Contracts

In my forthcoming Journal of Finance paper, Share Repurchases and Pay-Performance Sensitivity of Employee Compensation Contracts, I explore how share repurchases affect existing employee compensation contracts and offer a new explanation for the popularity of stock buybacks. Specifically, at the time of a share repurchase, employees are not permitted to tender their unvested shares, and the pay-performance sensitivity of their contracts increases. This increased employee ownership (measured by the dollar change in compensation per dollar change in firm value) creates stronger incentives for employees to provide effort, but also exposes them to greater risk. For example, a repurchase of 7% of common shares provides a 7.5% increase in employee incentives and can substitute for about half of a typical annual equity grant. Given the incentive effect of stock buybacks, managers (who make payout decisions) can benefit from stock repurchases by effectively forcing higher incentives on employees (who do not influence the firm’s payout policy).

Using a sample of 1,295 open market repurchase announcements and hand-collected data on employee stock option programs over the 1996 to 2002 period, I find that announcement returns are larger in firms with larger repurchase programs and many unvested stock options. The effect is most powerful when employees (not managers) have large amounts of unvested ownership and when firms intensively use human capital. In addition, I find that the method of payout chosen by the firm (stock repurchase versus dividend increase) is affected by the compensation structure at the firm. I find that repurchases are more likely to be announced when employees hold many unvested stock options, particularly when firms have a greater need for human capital, as measured by their R&D expenses and Tobin’s Q. Consistent with the diversification motive of risk-averse employees, I find that stock option exercises are positively related to the fraction of repurchased equity. A one-standard deviation increase in the fraction of repurchased equity is associated with a 30% increase in stock option exercises by managers and a 19% increase by employees, controlling for factors such as stock returns, market-to-strike ratios, and contemporaneous option grants, among others. The increase in stock option exercises is more pronounced for firms with highly volatile stock returns, supporting the view that employees exercise their stock options because of the increased risk exposure.

The rationale for open market share repurchases proposed in this paper is unrelated to the undervaluation and excess cash distribution motives explored elsewhere in the payout literature. While my empirical and theoretical results do not rule out undervaluation or other repurchase motives, the argument of this paper is that managers also repurchase stock to boost employee incentives.

The full paper is available for download here.