Share Repurchases and Pay-Performance Sensitivity of Employee Compensation Contracts

(Editor’s Note: This post comes to us from Ilona Babenko of the Department of Finance at the Hong Kong University of Science and Technology.)

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.