Option Grants and Risky Projects: A Reputation-Based Perspective

Studies of employee stock options have focused on the agency problem that arises when risk-averse managers are hired to select projects that introduce volatility to firm performance. In contrast, I investigate how the reputation cost of failure influences managers’ project choices and how firms contract to mitigate the resulting agency problem. I use data on a shock to the growth opportunities of firms that contract with the U.S. Department of Defense to identify a setting where the reputation cost of failure is the dominant form of risk that managers face when selecting projects. In this setting, I use a difference-in-differences approach to show that firms increase grants of employee stock options in response to this shock to uncertain growth opportunities, holding constant traditional determinants of option compensation. In the same setting I find a negative treatment effect on stock volatility. I also provide evidence that the granting response to this shock is most pronounced among managers with high reputation concerns. Finally, I find that these option grants are associated with both increased investment activity and increased contracting with the Department of Defense.