In recent years, corporations have distributed increasing amounts of cash through share repurchases. As reported by the Securities Data Corporation, the aggregate value spent by companies on stock buyback programs grew from $38 billion in 1993 to over $100 billion in 2003, peaking in 1998 with an astounding value of $230 billion.
This paper explores how share repurchases affect the extant employee compensation contracts and offer a new explanation for the popularity of stock buybacks. Since at the time of repurchase employees cannot tender unvested shares, the pay-performance sensitivity of their contracts increases. This increased employee ownership (measured by dollar change in compensation for a dollar change in firm’s value) creates stronger incentives for employees to provide costly effort, but also exposes them to higher risk. For example, a repurchase of 7% of common shares provides a 7:5% increase in employees’ incentives and can substitute for about half of a typical annual equity grant.1 Given the incentive effect of stock buybacks, the managers, who make payout decisions, can benefit by repurchasing stock because by doing so they can effectively force higher incentives on employees, who cannot influence firm’s payout policy.