Why Firms Issue Stock to Their Own Employees?
50 Pages Posted: 8 Dec 2008 Last revised: 18 Mar 2012
Date Written: June 19, 2011
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: Suggested Citation