We analyze participation decisions in employee stock purchase plans. These plans allow employees to buy company stock at a discount from the market price and resell it immediately for a sure profit. Although an average employee stands to gain $3,079 annually, only 30% of individuals take advantage of this risk-free opportunity. Participation is more likely among employees who are familiar with stocks, are more educated, are less financially constrained, and make fewer errors in valuing financial securities. Our results suggest that compensation plans requiring active decisions by individuals can result in poor financial outcomes for employees of lower socioeconomic status.

Employees tend to exercise stock options when corporate taxable income is high, shifting corporate tax deductions to years with higher tax rates. If firms paid employees the same dollar value in wages instead of stock options, the average annual tax bill for large U.S. companies would increase by $12.6 million, or 9.8%. These direct tax benefits of options increase in the convexity of the tax function. In addition, profitable firms can realize indirect tax benefits because stock options increase debt capacity. Although tax minimization is probably not the main motive for option grants, firms with larger potential tax benefits grant more options.

We show that unpriced cash flow shocks contain information about future priced risk. A positive idiosyncratic shock decreases the sensitivity of firm value to priced risk factors and simultaneously increases firm size and idiosyncratic risk. A simple model can therefore explain book‐to‐market and size anomalies, as well as the negative relation between idiosyncratic volatility and stock returns. Empirically, we find that anomalies are more pronounced for firms with high idiosyncratic cash flow volatility. More generally, our results imply that any economic variable correlated with the history of idiosyncratic shocks can help to explain expected stock returns.

We analyze how employee compensation contracts of target firms affect merger terms and outcomes. Using unique data from merger agreements, we document that in 80.0% of all merger and acquisition (M&A) deals, at least some of the target’s employee stock options (ESOs) are canceled by the acquirer and not replaced by new equity-based grants. Contract modifications reduce the value of ESOs by 38.4% in the average M&A deal. Further, the combined merger returns are larger when employees experience greater losses. Overall, our results indicate that the benefits of reducing the number of ESOs outweigh the potential negative effects on firm value.

We study the relation between CEO and employee campaign contributions and find that CEO-supported political candidates receive 3 times more money from employees than candidates not supported by the CEO. This relation holds around CEO departures, including plausibly exogenous departures due to retirement or death. Equity returns are significantly higher when CEO-supported candidates win elections than when employee-supported candidates win, suggesting that CEOs’ campaign contributions are more aligned with the interests of shareholders than are employee contributions. Finally, employees whose donations are misaligned with their CEOs’ political preferences are more likely to leave their employer.

Exercises of employee stock options generate substantial cash inflows to the firm. These cash inflows substitute for costly external finance in those states of the world in which the demand for investment is high. Using the fact that the proceeds from option exercises exhibit a distinct nonlinearity around the point where options fall out of the money, we estimate that firms increase investment by $0.34 for each dollar received from the exercise of stock options. Firms that face higher external financing costs allocate more of the proceeds from option exercises to investment.