Information‐based early exercise of US employee stock options

Abstract

PurposeThis paper aims to show that tax‐motivated early exercise of US employee stock options can be, in principle, rationalized for bullish executives. The paper aims to show empirical evidence consistent with private positive information guiding the timing of the exercises.Design/methodology/approachThe paper uses conventional event study methodology to examine the long‐run relative stock price performance of firms in which executives early exercise and maintain the acquired shares. The long‐run analysis adopts the cumulative abnormal return as well as the buy‐and‐hold methodological approach.FindingsTax‐motivated early exercise may be justified on the grounds that future stock appreciation can be converted to long‐term capital gains if the shares are held for over one year while, should the stock decline, shares can be sold within a year to count for short‐term losses. The empirical results reveal that executives who early exercise and continue to hold a majority of the shares acquired do so before performance in their company stock is significantly better than a benchmark.Practical implicationsInformation‐based early exercise is not a harbinger of poor firm performance, as prior research has suggested. This paper illustrates that private positive information can motivate tax‐based early exercise of employee stock options. Prior research has mostly suggested it cannot. Stock retention upon early exercise indicates the optimism of the exerciser.Originality/valueThe first modeling of an exploitable tax asymmetry upon exercise of US employee stock options. The explicit separation of exercises likely based on positive inside information from those likely based on negative information or other non‐informative reasons.

Accrual Management and the Decision to Hold the Shares Acquired from the Exercise of Executive Stock Options

“…In this paper, we re-examine earnings management activity around stock option exercises in the context of research demonstrating that executives do not sell all shares immediately following exercise (Aboody et al 2008;Sternberg and Witte 2009;Kyriacou and Mase 2010;Huston and Smith 2012). Specifically, we examine two complementary factors that help to explain the decision to hold shares acquired from option exercise, earnings management and tax incentives.…”

“…We include FUTRET6, computed as the value weighted buy-and-hold six month stock return excluding dividends beginning with the month of exercise to capture positive private information yet to be impounded into stock price at the time of the exercise. The findings of Aboody et al (2008), Sternberg and Witte (2009), and Huston and Smith would suggest a positive coefficient on FUTRET6. Finally, we include FUTEARNMAN6, computed as the combined accrual management for the 2 quarters reported after the month of exercise to capture any relation between future accrual management and the short-term decision to hold shares.…”

“…Limited existing research of the exercise and hold decision generally argues that executives anticipate favorable economic performance for the firm that will result in stock price appreciation. Aboody et al (2008), Sternberg and Witte (2009), Cicero (2009), and Huston and Smith (2012) use ex-post realized future returns to proxy for private information possessed by insiders at the time of exercise and document a positive relation with the decision to hold shares.…”

“…We also include control variables that prior research by Aboody et al (2008), Sternberg and Witte (2009), and Huston and Smith (2012) have found to be associated with the decision to hold shares acquired through exercise. We identify option exercises that likely do not represent a voluntary early exercise by identifying options set to expire within one year of exercise (EXPIRE).…”

“…Prior literature examining the managerial incentives associated with executive stock options (ESOs) implicitly assumes that managers immediately sell shares acquired through stock option exercises (Ofek and Yermack 2000;Core and Guay 2001;Carpenter and Remmers 2001;Huddart and Lang 2003;Bartov and Mohanram 2004). However, subsequent research in this area suggests that this assumption is not necessarily valid (Aboody, Hughes, Liu, and Su 2008;Sternberg and Witte 2009;Kyriacou and Mase 2010;Huston and Smith 2012), as these studies document a significant number of insiders instead choosing to hold shares obtained from ESOs for more than 30 days. Given the recent findings of exercise and hold behavior, we examine two factors that help to explain the decision to hold shares acquired from the exercise of optionsearnings management and tax incentives.…”