The Option to Quit: The Effect of Employee Stock Options on Turnover

Serdar Aldatmaz is Assistant Professor of Finance at the George Mason University School of Business; Paige Ouimet is Associate Professor of Finance at The University of North Carolina at Chapel Hill Kenan-Flagler Business School; and Edward Dickersin Van Wesep is an Associate Professor of Finance at the University of Colorado at Boulder Leeds School of Business. This post is based on their recent paper.

Firms employing highly skilled workers bear substantial direct and indirect costs when those workers quit. Hiring is expensive and departing workers can take institutional knowledge and intellectual property with them. These costs were high enough to induce Google, Apple, and other Silicon Valley firms to illegally collude not to hire each other’s workers, ultimately leading to a class-action lawsuit and a $415 million settlement in 2015. Turnover matters.

Theory suggests that broad-based employee stock option (BBSO) grants are a natural solution to turnover risk. These options typically vest in three years and an employee who departs before her options have vested forfeits their value. This is a clear incentive against quitting. In addition, an employee’s unvested options are worth more when the stock market is strong, which tends to correspond to periods of strong demand for workers. BBSOs therefore provide retention benefits that are stronger when the firm’s value from retaining employees is higher, and when the threat from other firms poaching employees is higher.

While the theory is clear, it is an open question as to what the actual effect of BBSOs on turnover is in practice. Our recently published paper, The Option to Quit: The Effect of Employee Stock Options on Turnover, aims to answer this question. We exploit a large panel of establishment-level data to show that BBSO grants delay turnover. Turnover falls during the vesting period of a BBSO grant, and rises by an approximately equal amount in the year following full vesting. We also find that BBSO plans are associated with a stronger reduction in turnover in up markets, when growth options are high and retaining key employees is likely to be especially valuable.

In the three years following a large BBSO grant (the year of the grant and the subsequent two years), during which the granted options are not fully vested, turnover falls at the granting firm. This does not appear to be merely a correlation: the association with BBSO grants and subsequent turnover is only present if the stock market has performed well since the grant. This suggests a causal interpretation of the correlation, because the value of the unvested BBSOs is small if the market has performed poorly since they were issued, so the effect on turnover should be small as well. Only if the market has performed relatively well since the grant date does the theory suggest that there should be an effect on turnover.

The reduction in turnover is approximately 0.005% of employment per quarter, which aggregates to 2% per year. If a typical firm experiences 20% turnover annually, and if approximately half of workers receive BBSOs, then the implementation of a BBSO plan reduces turnover by 20%, a substantial reduction. This estimate is robust across a wide variety of specifications, suggesting that it is not spurious.

In the fourth year following a large BBSO grant, when the options are probably fully vested, turnover is actually higher at granting firms. We find that, on average, 87% of the reduction in turnover observed in the first three years is reversed in the subsequent year. Furthermore, a number of firms issue multiple large BBSO grants. To the extent that a second large BBSO grant timed years after the first grant reduces future turnover, we are underestimating the reversal. This number suggests that, summing total turnover over the four years following a grant, the total effect is close to zero. This means that BBSOs are delaying turnover, not permanently reducing it. Executives estimating the value of a turnover reduction must account for its temporary nature.

We cannot say that BBSO plans are or are not worth the cost, and we do not suggest that retention is the only justification for employee stock options. They are very expensive and clearly can serve an incentive role, screen for optimistic employees, etc. Nonetheless, the effect on turnover is also important and should be considered a first-order benefit of employee stock options. Also, even though the effect on turnover is temporary, BBSOs could still be beneficial if implemented during a period when retaining existing human capital is particularly valuable, for example, a period of high demand and high anticipated turnover.

The complete paper is available here.

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