Stock options have become a significant feature in employee compensation packages. From 1992-2000, the value of employee stock options in the US grew more than 10-fold, from $11 billion to $119 billion. Their attractions are obvious enough: they provide incentives to employees, help to attract and retain qualified staff, and can be a substitute for cash compensation in financially-strapped firms. A new study suggests there's yet another benefit: they can be a source of finance, especially for firms that face high external financing costs.

Ilona Babenkoand Yuri Tserlukevich of HKUST and their co-author Michael Lemmon say that stock options are attractive for firms because they provide both cash and tax benefits when they are exercised - and they tend to be exercised when the stock price is high and the firm presumably has good investment opportunities. This means that a firm is able to increase its investment when the demand for investment is high relative to internal resources.

The authors provide evidence for this by looking at the option exercises and investments of more than 1,400 firms from 2000-2005. Money earned through the exercises was associated with an increase in investment.

"Our estimates indicate about $0.34 of each dollar of cash inflows received by firms from the exercise of employee stock options is allocated to increasing capital and R&D expenditures," they say. The effect was more pronounced for R&D expenditures, and it was also greater than that obtained through seasoned equity offerings.

The effect was not equal across all firms, though. Investment by firms that faced greater investment demand relative to internal cash flow, and those with higher marginal costs of external financing, were more sensitive to option-related cash flows.

The authors also considered the impact of firm approaches to repurchasing stock. Other research has suggested managers concerned about earnings-per-share might divert funds from profitable investments to repurchase stock, but this was not found to be the case here.

"In contrast to investment, stock repurchase is unrelated to cash inflows in firms facing high demand for external finance and those with higher marginal financing costs, but it is positively correlated with proceeds in firms with easy access to external finance."

"It appears that firms with low demand for external capital return the proceeds from option exercises to shareholders, while firms facing high external financing costs use these additional cash flows to finance investment."

The authors suggest that the design of compensation packages for employees should take into account the significant role that employee stock options play in providing funds to firms.

"Indirect equity issues to employees as part of compensation plans are an important source of financing, particularly for firms with limited internal liquidity and those facing high costs of accessing capital markets," they say.