Essays on employee stock options

This dissertation investigates a new rationale for employee stock options (ESOs). It uses a market valuation model to explore why firms grant employee stock options. When insider managers and outside investors have different opinions about the future prospects of the firm, employee stock options can be used to capture future investor overvaluation and to save employee compensation costs. Options can enhance the stock value for existing shareholders if the difference in opinion is highly volatile. The equilibrium option grant is positively correlated with both the perception error of investors, and the volatility of this error, as well as the correlation between investors' error and firm fundamental value. The model implications on the cross-sectional differences in option grants are examined empirically. I find strong empirical evidence that firms with high market valuation and high probability of future overvaluation are more likely to adopt ESOs and grant more options to their employees. Furthermore, when top executives perceive the current market valuation is high, they grant a smaller portion of options to themselves relative to rank-and-file employees. All these results are consistent with the model which argues that ESOs can be used as a method to sell overvalued equity.