Information‐based early exercise of US employee stock options

Abstract

Purpose

This 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/approach

The 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.

Findings

Tax‐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 implications

Information‐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/value

The 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.

Citation

Sternberg, J.S. and Doug Witte, H. (2009), "Information‐based early exercise of US employee stock options", Studies in Economics and Finance, Vol. 26 No. 1, pp. 4-23. https://doi.org/10.1108/10867370910946298