The Impact of Stock‐Option Compensation for Outside Directors on Firm Value*

We examine the characteristics of firms that adopt stock-option plans for outside directors using a sample of 2,088 firm-year observations of Fortune 1000 firms from 1997-1999. Using fixed-effects models that account for self-selectivity bias, we find that firms with outside director option plans have significantly higher market to book ratios and profitability metrics. Adoptions of these option plans are also associated with significantly positive cumulative abnormal stock returns (CARs) as well as with favorable revisions in analysts' earnings forecasts. In addition, announcements of outside director appointments are related with CARs close to zero for firms with option plans, but with significantly negative CARs for firms without option plans. We conclude that stock option plans for outside directors help align the incentives of outside directors and shareholders, thereby improving firm value.