Employee Sentiment and Stock Option Compensation

64 Pages Posted: 10 Mar 2005

See all articles by Nittai Bergman

Nittai Bergman

Tel Aviv University; National Bureau of Economic Research (NBER)

Dirk Jenter

London School of Economics & Political Science (LSE) - Department of Finance; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: February 2005

Abstract

The use of equity-based compensation for employees in the lower ranks of large organizations is a puzzle for standard economic theory: undiversified employees should discount company equity heavily, and any positive incentive effects should be diminished by free rider problems. We analyze whether the popularity of option compensation for rank and file employees may be driven by employee optimism. We develop a model of optimal compensation policy for a firm faced with employees with positive or negative sentiment, and explicitly take into account that current and potential employees are able to purchase equity in the firm through the stock market. We show that employee optimism by itself is insufficient to make equity compensation optimal for the firm. Any behavioral explanation for equity compensation based on employee optimism requires two ingredients: first, employees need be over-optimistic about firm value, and second, firms must be able to extract part of the implied rents even though employees can purchase company equity in the market. Such rent extraction becomes feasible if employees prefer the non-traded compensation options offered by firms to the traded equity offered by the market, or if the traded equity is overvalued. We then provide empirical evidence confirming that firms use broad-based option compensation when boundedly rational employees are likely to be excessively optimistic about company stock, and when employees are likely to have a strict preference for options over stock.

Keywords: Option Compensation, Employee Sentiment

JEL Classification: G30, J33, M52

Suggested Citation

Bergman, Nittai and Jenter, Dirk, Employee Sentiment and Stock Option Compensation (February 2005). MIT Sloan Research Paper No. 4504-04; AFA 2004 San Diego Meetings; EFA 2005 Moscow Meetings Paper. Available at SSRN: https://ssrn.com/abstract=587426 or http://dx.doi.org/10.2139/ssrn.587426

Nittai Bergman

Tel Aviv University

Ramat Aviv
Tel-Aviv, 6997801
Israel

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Dirk Jenter (Contact Author)

London School of Economics & Political Science (LSE) - Department of Finance ( email )

United Kingdom

HOME PAGE: http://personal.lse.ac.uk/jenter/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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