Why Firms Issue Stock to Their Own Employees?

50 Pages Posted: 8 Dec 2008 Last revised: 18 Mar 2012

Date Written: June 19, 2011

Abstract

This paper shows that issuing shares to firm employees instead of outside investors mitigates the adverse selection problem and lowers cost of capital. For a firm that repeatedly needs funds, the incentives to grant overvalued equity to employees are reduced because employees can rationally deprive the firm of fairly-priced financing after a poor stock price performance. The model explains stylized facts, such as a positive relation between risk and incentives, improvements in operating performance after stock-based grants, and systematic overvaluation by employees of their equity-based compensation. Additionally, it shows that combining outside equity financing with stock-based grants to employees allows the firm to signal value and to price new equity issues more favorably. Empirical evidence provides support to the main predictions of the model.

Keywords: stock options, signaling, adverse selection, asymmetric information

JEL Classification: D82, D86, G30, G32

Suggested Citation

Babenko, Ilona, Why Firms Issue Stock to Their Own Employees? (June 19, 2011). Available at SSRN: https://ssrn.com/abstract=1312940 or http://dx.doi.org/10.2139/ssrn.1312940

Ilona Babenko (Contact Author)

Arizona State University ( email )

Department of Finance
W.P. Carey School of Business
Tempe, AZ 85287
United States

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