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Does Risk Matter? Corporate Insider Transactions in Internet-Based Firms

This paper investigates an unintended consequence of equity-based compensation plans: in highly volatile firms, managers appear to undermine the compensation system's intended effect of aligning managers' interests with those of shareholders. Specifically, many managers are selling at least a portion of their equity stakes, or exercising their stock options and selling the acquired shares. These sales may reduce the desired incentive-alignment; they also have the potential to directly decrease equity value if market participants interpret the sales as a signal that managers believe their firms to be overvalued. But overvaluation is not the only reason that these corporate insiders sell. Many managers in Internet-firms have undiversified portfolios, holding mainly the equity of their firms. This lack of diversification, combined with the high volatility of Internet-based firms, and the limited control managers have over that volatility, gives managers an incentive to diversify by selling their stock holdings, irrespective of their beliefs about the accuracy of the current stock price. Indeed, based upon the average Internet firm's volatility of 113% annually (relative to the 22% of the S&P 500 Index), a non-diversified insider would be better off selling shares to diversify even if he/she believed the firm to be undervalued by the market by almost 50%. This paper investigates whether the market response to insider selling in Internet-based companies reflects these multi-faceted incentives. I find that, in contrast to insider selling in the general population of firms, sales in Internet-based companies do not produce negative excess returns (the mean return on an insider selling day is +0.82%, net-of-market movements, for an Internet-based firm). This result suggests that market participants do not, on average, interpret managerial sales in Internet-based as a signal of overvaluation. The relatively high incidence of managerial sales in Internet-based firms may instead reflect the high value managers' place on holding a diversified portfolio, an observation that raises questions about the optimal compensation-mix in such firms.