How to Retain Managerial Top Talent?
The unplanned departure of a top manager is a highly costly and disruptive event. For example, Burberry’s stock price plunged 8% when CEO Angela Ahrendts announced in 2013 that she was leaving to run Apple’s retail operations. Leading firms such as Google similarly identify the loss of top talent as a key risk factor for future growth. Firms are uncertain, nonetheless, how to prevent such departures, and are currently experimenting with a diverse range of ideas to promote loyalty among their top performers.
This raises an important question: How can firms effectively retain their top executives. One way that firms can use to prevent executives from leaving is to defer some of their compensation into the future. Unvested equity pay can be a particularly effective retention mechanism. What is unvested equity? These are equity grants that typically vest only after four to five years, and before these grants vest, managers cannot cash in the money. This can have quite strong retention effects, as executives who voluntarily leave before this period ends forfeit their unvested equity.
In my paper “The Retention Effects of Unvested Equity: Evidence from Accelerated Option Vesting”, me and my co-authors Tomislav Ladika and Torsten Jochem document a large spike in executive turnover following the sudden elimination of equity vesting periods. The full paper is available here.
Our analysis examines a unique feature of an important accounting change (FAS123-R), which was adopted in December 2004 and 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. However, 767 firms exploited a regulatory exemption to avoid these expenses: they accelerated executives’ previously granted options to vest immediately, instead of over several years as originally scheduled. This allowed firms to report higher net income than competitors, but also reduced executives’ departure costs from forfeiting unvested equity by 64%. We use this large one-time shock from option acceleration to estimate how unvested equity affects executive retention.
We find that a one-standard-deviation increase in the fraction of options accelerated leads to a rise in the CEO turnover rate from 6% to 19%, and in the top executive turnover rate from 8% to 16%. These are large effects. We then examine how the spike in turnover affected the value of firms that lost executives. Departures following option acceleration were relatively sudden, so they may have disrupted firms’ business plans and led to costly CEO replacements. Indeed, the stock prices of accelerating firms dropped by 1.5% in a three-day window around voluntary CEO departure announcements, erasing USD 26 million in firms’ market values.
We further find that firms responded to departures by increasing the compensation of remaining executives and newly hired CEOs. Accelerating firms that experienced a departure subsequently raise non-departing executives’ total pay by 15%. We also find that newly hired CEOs received 44% higher pay than the departing CEOs whom they replaced. These results indicate that executive turnover, while costly, allowed firms to learn about the value of top executives’ outside options.
Our results are important for management practice as they imply that firms can effectively prevent turnover of top executives by deferring a portion of their annual pay.