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The Retention Effects of Unvested Equity: Evidence from Accelerated Option Vesting

The Retention Effects of Unvested Equity: Evidence from Accelerated Option Vesting Abstract We document that firms can effectively retain executives by granting deferred equity pay. We show this by analyzing a unique regulatory change (FAS 123-R) that prompted 723 firms to suddenly eliminate stock option vesting periods. This allowed CEOs to keep 33% more options when departing the firm, and we find that voluntary CEO departure rates subsequently rose from 5% to 21%. Our identification strategy exploits FAS 123-R’s almost-random timing, which was staggered by firms’ fiscal year-ends. Firms that experienced departures suffered negative stock price reactions, and responded by increasing compensation for remaining and newly hired executives. Received June 6, 2016; editorial decision October 10, 2017 by Editor Andrew Karolyi. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online. Demand for general human capital is rising across the economy, which makes it important to understand how firms can retain highly talented managers. One key retention mechanism that contract theory proposes is to defer parts of managers’ compensation into the future, by granting equity that does not vest for several years (Edmans et al. 2012). Managers who voluntarily depart their firms typically forfeit unvested equity, which raises their cost of pursuing an outside option. Boards often grant managers large amounts of time-vesting equity based on this rationale (Ittner, Lambert, and Larcker 2003). Nevertheless, whether unvested equity actually conveys retention incentives is unclear, for several reasons. First, firms may grant unvested equity primarily to provide incentives against myopic behavior, rather than to retain talent (Gopalan et al. 2014; Edmans, Fang, and Lewellen 2017). Second, poaching firms sometimes provide upfront payments that partially compensate managers for forfeiting unvested equity (Xu and Yang 2016).1 Third, models of managerial labor markets highlight that firms’ compensation policies can affect the type of managers that self-select to work for them (Lazear 2005). This endogenous sorting makes it difficult to understand whether retention is driven by firms’ vesting policies or managers’ attributes.2 As a result of these factors, causal identification is challenging, and this may explain why existing empirical work has been unable to link unvested equity to executive turnover (Fee and Hadlock 2003). This paper presents novel evidence on the retention incentives of deferred compensation. We study how executive turnover changes following the sudden elimination of stock option vesting restrictions by means of a major regulatory change in the United States, and document three primary findings. First, voluntary CEO turnover rises significantly when the amount of options forfeited upon leaving decreases. This effect is stronger when the previously unvested options are more valuable. Second, these departures precipitate declines in firm value. Third, firms respond to turnover by raising the pay of remaining executives and newly hired CEOs, implying that departures allow firms to update their beliefs about executives’ outside options. Our findings provide insights into the dynamics of managerial labor markets, and complement the literature on the determinants of forced turnover (Huson, Parrino, and Starks 2001; Eisfeldt and Kuhnen 2013; Jenter and Kanaan 2015). We establish these results by exploiting a unique feature of the accounting regulation FAS 123-R, which required firms for the first time to expense stock options in their financial statements. FAS 123-R imposed retroactive accounting charges on unvested options that firms had granted years before the standard’s adoption in December 2004. Corporate leaders vehemently opposed the new accounting expenses, which they feared would lead to a sudden drop in earnings. Motivated by such concerns, 723 firms exploited a regulatory exemption: They accelerated executives’ previously granted, unvested options to vest immediately, thereby avoiding a 23% dropoff in net income (Choudhary, Rajgopal, and Venkatachalam 2009). At the same time, however, option acceleration shortened the time until a CEO’s options vested by 19 months on average, and increased the value of their vested option holdings by 33%. This allowed departing CEOs to keep an additional $${\$}$$0.8m worth of options, an amount equal to their annual equity pay. Our hypothesis is that this sudden, large drop in departure costs led to an increase in executive turnover. A challenge to testing this hypothesis is that firms’ decisions to accelerate option vesting are endogenous. First, some unobservable variables likely affected both option acceleration and turnover. Second, estimates could be affected by reverse causality, if some firms accelerated options to provide a “golden handshake” to outgoing ex