The Retention Effects of Unvested Equity: Evidence from Accelerated Option Vesting

Torsten Jochem is Assistant Professor of Finance at the University of Amsterdam; Tomislav Ladika is Assistant Professor of Finance at the University of Amsterdam; and Zacharias Sautner is Professor of Finance at Frankfurt School of Finance & Management. This post is based on their recent article, forthcoming in The Review of Financial Studies.

Demand for general human capital is rising across the economy, which makes it important to understand how firms can retain highly talented managers. One key retention mechanism is to defer parts of managers’ compensation into the future, by granting equity that does not vest for several years. Managers who voluntarily depart their firms typically forfeit unvested equity, which raises their cost of pursuing an outside option.

In our article, The Retention Effects of Unvested Equity: Evidence from Accelerated Option Vesting, forthcoming in the Review of Financial Studies and publicly available on SSRN, we present novel evidence on the retention incentives of deferred compensation. We study how executive turnover changes following the sudden elimination of stock option vesting restrictions by means of a major regulatory change in the U.S., and document three findings. First, voluntary CEO turnover rises significantly when the amount of options forfeited upon leaving decreases. Second, these departures precipitate declines in firm value. Third, firms respond to turnover by raising the pay of remaining executives and newly hired CEOs, implying that departures allow firms to update their beliefs about executives’ outside options.

We establish these results by exploiting a unique feature of the accounting regulation FAS 123-R, which required firms for the first time to expense stock options in their financial statements. FAS 123-R imposed retroactive accounting charges on unvested options that firms had granted years before the standard’s adoption in December 2004. Corporate leaders vehemently opposed the new accounting expenses, which they feared would lead to a sudden drop in earnings. Motivated by such concerns, 723 firms exploited a regulatory exemption: They accelerated executives’ previously granted, unvested options to vest immediately, thereby avoiding a dropoff in net income. At the same time, however, option acceleration shortened the time until a CEO’s options vested by 19 months on average, and increased the value of their vested option holdings by 33%. This allowed departing CEOs to keep an additional $0.8m worth of options, an amount equal to their average annual equity pay. Our hypothesis is that this sudden, large drop in departure costs led to an increase in executive turnover.

A challenge to testing this hypothesis is that firms’ decisions to accelerate option vesting are endogenous. We overcome this challenge by using plausibly exogenous variation in option acceleration caused by FAS 123-R’s staggered compliance dates. Specifically, firms could avoid accounting expenses by accelerating options during the first fiscal year that ended after June 15, 2005. Thus, the acceleration deadline for firms with fiscal years ending between June and December 2005 (“late fiscal-year-end firms”) was already in calendar year 2005, whereas the deadline for firms with fiscal years ending between January and May 2006 (“early fiscal-year-end firms”) was only in calendar year 2006. We exploit this staggered compliance schedule by instrumenting for option acceleration using an indicator for whether firms had an early or late fiscal year-end. The first-stage tests whether firms accelerated more options during the fiscal year just prior to their required FAS 123-R compliance. The second stage then tests whether instrumented option acceleration led to higher CEO turnover during the next fiscal year.

Firms were 2.5 times more likely to accelerate option vesting in their fiscal year just prior to compliance with FAS 123-R. Firms’ fiscal year-ends also likely satisfy the exclusion restriction for an instrumental variable, as they were set years in advance of FAS 123-R and thus should be uncorrelated with any contemporaneous changes that affect turnover. Early and late fiscal-year-end firms also had identical turnover rates, firm characteristics, and CEO pay before FAS 123-R took effect.

We show that prior to FAS 123-R, turnover rates were similar across firms that accelerated in 2005 or in 2006. Turnover then rose sharply after the regulation took effect, at first only for the firms that accelerated in 2005, and one year later for firms that accelerated in 2006. Our regressions show that a one-standard-deviation increase in the fraction of options accelerated led to a rise in the voluntary CEO turnover rate from 5% to 21.2%. Turnover rose more among CEOs who would have waited longer for options to vest in the absence of acceleration, whose unvested options were more in the money, and whose vested option holdings increased by a larger amount. We also find that turnover among a broader set of top executives rose from 8.8% to 21.3%.

Because departures following option acceleration were relatively sudden, they may have reduced value by disrupting firms. We find that accelerating firms’ abnormal stock returns were -1.5% in a 3-day window around voluntary CEO departure announcements, erasing $29m in value on average. This indicates that markets perceived acceleration-induced CEO departures to be costly. Accelerating firms were also more likely to resort to appointing an interim CEO than non-accelerating firms with CEO departures and spent 106 days longer searching for a permanent replacement.

Departures allowed firms to learn about executives’ outside options and the required level of retention incentives.  Firms that experienced turnover following acceleration were more likely to discuss retention issues in their proxy filings following the departures. Moreover, such firms subsequently raised non-departing executives’ pay by 11% on average, and newly hired CEOs’ pay by 32%, relative to accelerating firms that experienced no turnover.

Our results provide evidence that vesting periods are an important tool for retaining executives. This implication is important for firms that are designing recruitment and retention strategies, especially in industries with fierce competition for top talent. Our findings are also relevant for policymakers who are debating new regulations on executive compensation, such as requirements that banks defer the payout of their executives’ bonuses. Our setting may also be useful for future research on the extent to which labor market frictions affect the allocation of managerial talent across firms.

The complete article is available for download here.

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