Prior literature suggests three explanations for granting stock options as a form of compensation to non-executive employees. Broad-based option grants can be used as an incentives tool, a sorting mechanism, and a means of assisting with employee retention. An alternative explanation is that financially constrained firms use broad-based option grants as a form of self-financing. Using empirical data on broad-based option grants, a financial constraints index and individual variable proxies for financial constraints, we examine the relationship between option grants and the severity of financial constraints to which the firm is subject. We find that direct financial benefits to the firm from the use of option grants are possible. However, sorting is more likely reason for using broad-based option grants, while self-financing is a positive side effect of sorting.

Using simulated returns series and empirically observed stock returns, we show that broad-based option grants can generally lead to direct financial benefits for the company. Cash resources can be preserved internally by substituting options for a portion of payment in cash. However, the substitution of options for $1000 cash pay will result in only $10-$30 dollars of savings to the firm. This raises the question of whether savings of this magnitude can be universally considered as economically significant. We find that the sorting mechanisms in option grants and the financial-constraints explanation cannot be easily separated and both hypotheses should be studied jointly. The financing-constraints explanation for option grants can simply be a positive supplement to the sorting processes in compensating structures used by the firms.