20110718 what determines stock option contract designs

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Journal of Financial Economics

Journal of Financial Economics ] (]]]]) ]]]–]]]

0304-40

doi:10.1

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What determines stock option contract design?$

Eva Liljeblom, Daniel Pasternack n, Matts Rosenberg

Hanken School of Economics and Business Administration, P.O. Box 479, 00101 Helsinki, Finland

a r t i c l e i n f o

Article history:

Received 19 January 2010

Received in revised form

14 December 2010

Accepted 15 February 2011

JEL classification:

G30

G32

J33

Keywords:

Stock option contract design

Optimal contracting

Agency cost

5X/$ - see front matter & 2011 Elsevier B.V.

016/j.jfineco.2011.02.021

are greatly indebted to valuable comments

thank Tom Berglund, Seppo Ikaheimo, Esa

, Darius Miller, Vesa Puttonen, the partici

op on Capital Markets & Financial Economic

f the GSFFA Joint Finance Research Seminar

nd suggestions.

esponding author. Tel.: þ358 505693416.

ail address: [email protected] (D. P

e cite this article as: Liljeblom, E.,omics (2011), doi:10.1016/j.jfineco.2

a b s t r a c t

We analyze the factors that drive exercise price policy for executive option plans

(ESOPs) and their scope in a country where firms are not subject to the tax and

accounting considerations that seem to have led to the dominance of at-the-money

options in the US Our ‘‘unbounded’’ data for Finland provide us with an excellent

opportunity to investigate whether contract design is consistent with compensation

theory. Our findings are largely consistent with predictions from the optimal contract-

ing literature. The size of the plan is negatively related to Tobin’s Q and firm size and

positively related to proxies for monitoring costs, which also influence the probability

of launching premium ESOPs. Our results also show that the premium (out-of-the-

moneyness) is negatively related to prior stock returns and cash flow-to-assets, which

may be an indication of high-water mark contracting, or alternatively, of managerial

power. Finally, we also find some support for a positive relation between the premium

and the length of the vesting period when maturity is fixed, which indicates an effort to

keep the incentives for management from falling over time.

& 2011 Elsevier B.V. All rights reserved.

1 For example, Murphy (1999) documents that 95% of the chief

executive officer (CEO) stock options of 1,000 large US firms in 1992

were granted at-the-money. More recent results indicate that this still is

the case; e.g., Banerjee, Gatchev and Noe (2008) report that in 2005,

99.92% of new option grants to CEOs were issued at-the-money. For

Europe, Sauer and Sautner (2008) find that when underwater options are

1. Introduction

Most empirical studies of equity-based compensationconcentrate on the incentives they provide (e.g., Yermack,1995). Incentives are typically measured by some (abso-lute or relative) measure of pay-to-performance sensiti-vity. For executive options, the pay-to-performance sen-sitivity is a function of the option delta (i.e., related to theexercise price in relation to the stock price as well as, e.g.,stock volatility) and the grant size [see, e.g., the option-specific pay-performance sensitivity of Hall and Murphy(2000, 2002)]. Hall and Murphy (2000) consider theexercise-price policy as perhaps the most central designissue regarding executive options. Paradoxically, the

All rights reserved.

by Professor Li Jin.

Jokivuolle, Anders

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variation of the key variable, the exercise price at thegrant date, has been rather limited in the US, where mostexecutive options have been granted near at-the-money.1

Hall and Murphy (2000, 2002) provide a rationale for thisphenomenon using elements related to managerial riskaversion and elements from US tax and accounting con-siderations.2 Additional arguments like these are needed

repriced, the new exercise price is set so that the median (mean) ratio of

the new exercise price to the reprising day stock price is 1.00 (1.21).

Their results thus indicate that in Europe as well, setting option exercise

prices near at-the-money is favored. In, e.g., Australia, however, a larger

variation in exercise prices can be found; see, e.g., Rosser and Canil

(2004).2 Their main explanation is based on an analysis of the optimal pay-

to-performance sensitivities given risk-averse managers who may have

a large proportion of their wealth in company stock or options. They find

that the incentive-maximizing exercise price range is relatively flat and

ines stock option contract design? Journal of Financial

www.elsevier.com/locate/jfec

dx.doi.org/10.1016/j.jfineco.2011.02.021

mailto:[email protected]



E. Liljeblom et al. / Journal of Financial Economics ] (]]]]) ]]]–]]]2

because, without them, the predominance of at-the-money options would partly remain a puzzle given theflatness of the incentive-maximizing exercise price range.

We provide unique evidence of the determinants ofstock option design using data for a market whereexercise price setting is not restricted by tax or account-ing considerations. Such a setting allows us to investigatethe factors that drive the key variable, exercise price,which varies little in the US Recent contributions by,for example, Dittmann and Yu (2009) and Palmon andVenezia (2009) suggest that options should be in-the-money (at least in the absence of US tax considerations).Our sample, where the setting of the exercise price is‘‘unbounded’’ by institutional restrictions, serves as anexcellent experimental laboratory for such theoreticalpredictions. In addition to exercise price, we examineanother important design attribute, the scope of the plan[for other important features of stock option programs,such as vesting schedules and contract maturity, see, e.g.,Rosenberg (2003)]. Finally, we also study the effect of thevesting period on the exercise price. Bebchuk, Fried, andWalker (2002) notice that little attention is given to thefact that firms (in the US) use the same exercise price foroptions regardless of the vesting period. Our tranche-specific stock option data for Finland allow us to studythis issue, in a setting where exercise price setting isrelatively free of restrictions as compared with the US.

We find that the ratio of the exercise price to the stockprice on the granting date (the out-of-the-moneyness ofthe option) is negatively related to the prior stock return.This result may be interpreted as a shareholder responseto a poor prior stock price performance by requiring ahigher subsequent stock price appreciation to rewardmanagers (high-water mark contracting). Alternatively,the result suggests that managers have more negotiationpower regarding the design of compensation in firms withgreater prior stock price performance. Our additional testsdo not allow us to strongly distinguish between these twoalternatives. Moreover, our results indicate that invest-ment intensity, cash flow, and monitoring costs areassociated with the likelihood of granting premium(out-of-the-money) stock options.

Our results show that the scope (measured as thefraction of equity obtained upon the exercise of allgranted stock options) is negatively related to Tobin’s Q.If Tobin’s Q is treated as a measure of firm performance,

(footnote continued)

mostly surrounds the at-the-money point. However, e.g., Hall and

Murphy (2000) believe that US tax and accounting rules can explain

the paucity of discount (in-the-money) options (but not the paucity of

premium options). In the US, in-the-money stock options have not been

regarded as ‘‘performance-based compensation’’ under Section 162(m)

of the Internal Revenue Code and thus do not constitute a tax-deductible

cost if an executive’s total non-performance-based compensation

exceeds $1 million per year. In addition, prior to 2005, stock options

that were granted in-the-money had to be included in the income

statement as a compensation expense, whereas fixed-plan options

granted at-the-money and out-of-the-money did not have to be. With

the introduction of Financial Accounting Standard (FAS) 123(R) came a

mandatory option expensing for financial statements with fiscal years

beginning after June 15, 2005, which may influence the design of newer

executive option programs (Cuny, Martin, and Puthenpurackal, 2009).

Please cite this article as: Liljeblom, E., et al., What determEconomics (2011), doi:10.1016/j.jfineco.2011.02.021

this relation would suggest that poorly performing firmsgrant larger stock option plans with greater scope. Inaddition, we find that the scope of stock option plansincreases simultaneously with proxies for monitoringcosts, which is consistent with the traditional principal-agent theory that greater monitoring cost/difficultyshould be positively related to the amount of equity-based compensation (Holmstrom, 1979; Demsetz andLehn, 1985; Milgrom and Roberts, 1992). We also findthat the scope of the stock option plan is greater in broad-based plans and in plans with dividend protection.

Finally, we find that when institutional restrictionsconcerning exercise price setting are absent, there is asignificant positive relation between the out-of-the-money-ness of the option tranches and the length of their vestingperiod. This finding is contrary to the view of Bebchuk,Fried, and Walker (2002) that managerial power leads to thesame exercise prices ( ‘‘y a royalty on the passage of time,’’as Buffett put it3). Instead, our results suggests that whenboth the size of the compensation program and the exerciseprice are allowed to vary, firms set higher exercise prices foroptions with longer vesting periods to keep the incentiveeffect from diminishing over time.

We contribute to the relatively thin literature (as notedby Dahiya and Yermack, 2008) on inter-firm differences inthe design and implementation of executive stock optionplans. There are accepted theoretical arguments for usingdifferent design elements in different types of firms, forexample, due to differences in monitoring costs, but verylittle empirical evidence exists on their actual validity.Furthermore, while there has been little variation in theexercise price in the US and thus little focus on it as avariable, the introduction of FAS 123(R) in 2005 maychange this situation. By introducing mandatory optionsexpensing irrespectively of the in-the-moneyness of theoption, FAS 123(R) has ruled out some of the earlierobstacles to options other than fixed-plan at-the-moneyoptions. As a result, evidence from another market, whereoptions with varied exercise prices have been subject toequal treatment in tax and accounting rules, may be ofinterest with respect to the potential future developmentof other markets.

The paper is organized as follows. Section 2 providesbackground information on option grants in Finland andon the comparability of Finland to other markets. Section3 presents the hypotheses and the research design used inthe study. Sample selection and data characteristics arediscussed in Section 4. Section 5 reports the empiricalresults, and Section 6 concludes the paper.

2. Institutional details for Finland

2.1. Governance and executive compensation in Finland

Although Finland is a small country compared to theUS, we believe that analyzing the setting of exercise pricesin Finland can provide insight into the factors that mightdrive exercise price setting in other markets, such as

3 Speech held at Berkshire Hathaway annual meeting 2003.



E. Liljeblom et al. / Journal of Financial Economics ] (]]]]) ]]]–]]] 3

the US, when the institutional factors that drive towardsat-the-money options are no longer present. Comparedwith continental European countries, Finland is in manyways similar to the US in terms of corporate governance,business culture, and shareholder orientation. WhenAggarwal, Erel, Williamson, and Stultz (2009) compareforeign firms to US firms in terms of their level ofcorporate governance (CG), they find that the top fourCG countries are Canada (a CG score of 68%), the US (59%),Finland (56%), and the U.K. (55%).4

Also in terms of ownership concentration, Finlandrepresents a middle case between the typical Europeanpattern of concentrated ownership and the ownershipstructure in the US.5 With decreasing ownership concen-tration, and increased pension savings, institutional own-ers have become increasingly important in the Finnishmarket [see, e.g., Bhattacharya and Graham (2009), whostudy institutional owners in Finland]. Many institutionalinvestors in Finnish stocks are foreign funds. Severalauthors argue that the high degree of internationalizationhas driven Finnish CG and business culture towards morea competitive culture where shareholder value is given anincreasingly high priority.6

During our study period, the compensation mix for topexecutives in Finnish-listed firms typically includes a basesalary, a bonus, and executive options. Additional retire-ment (pension) benefits are also common. Stock-basedcompensation has gained in popularity since 2002, i.e.,after the period of the technology stock-market crash,when the popularity of option plans began to fade. In2005, stock-based compensation became slightly morecommon than executive options (Ikaheimo, Kontu,Kostiander, Tainio, and Uusitalo, 2007). In an internationalcomparison [Ikaheimo, Kontu, Kostiander, Tainio, and

4 Aggarwal, Erel, Williamson and Stultz (2009) also find that only

15 countries have at least one firm that has better governance than its

matching US firm. There are only three countries with more than five

firms that have a positive index gap, meaning that such firms invest

more in governance than their US counterpart: Canada, Finland, and the

U.K. In the case of Finland, 29.2% of the firms have a positive gap while

for the U.K., the percentage is 24.4%. An example of a specific CG

component where Finland ranked high was also the low level of

staggered boards. They document that four countries (Canada, Denmark,

Finland, and Sweden) have a much higher proportion of firms without a

staggered board as compared to the US.5 Korkeamaki, Liljeblom, and Pastenack (2010) report that less than

20% of the firms have a block holder owning more than 50% of the shares

in Finland, whereas the evidence in Barca and Becht (2001) indicates

that the percentage is more than 50% in, e.g., Austria, Belgium, Germany,

and Italy. There is also more cross-sectional variation in ownership

concentration in Finland as compared to Continental Europe, from very

widely held firms such as Nokia to firms with a more concentrated

ownership structure.6 See, e.g., Tainio and Lilja (2003) and Yla-Anttila, Ali-Yrkko, and

Nyberg (2004). In the latter, survey results are reported, showing the

high importance of profitability, and the increasing importance of

shareholder value, among the goals of large Finnish companies. In

Finland, between 40% to 60% of the stock market is owned by foreign

investors. Yla-Anttila, Ali-Yrkko, and Nyberg (2004) report that Finland

ranked as number two among 16 European countries as a cross-border

merger target, and that Finnish industrial corporations are highly

internationalized: amongst the ten largest corporations, as much as

80% of total revenues come from foreign sales and over 60% of the

production and the personnel is located in foreign units.


Uusitalo (2007), using data from 2005 for Finland, anddata from 2006 for other markets], the compensationstructure in Finland was found to be similar to that ofother European countries such as the U.K., Italy, France,and Sweden. Base salary counts for about 42% of totalcompensation, variable payment (bonus, options and/orstock-based compensation) for 35%, and pension andother benefits for the remaining 23%. In the US, thecorresponding percentage for base salary is only 27%.

Despite some differences in the compensation mix,executive compensation practices in Finland are similar tothose in the US in terms of their stock price sensitivity.Makinen (2007) finds that in Finland, the average compen-sation of CEOs increased substantially over time, and thatthis change, and especially when measured in terms of totalcompensation, is highly related to changes in stock marketmeasures of firm performance. His estimates of ‘‘semi-elasticities’’ of CEO salary and bonus with respect to stockreturns are between 0.09 and 0.28 for total compensation inFinland, values that are in line with those of Rosen (1992),who finds that the estimated ‘‘semi-elasticity’’ of CEOsalaries and bonuses with respect to stock returns is in the0.10–0.15 range for the US and the U.K. Makinen’s (2007)findings (for a more recent time period, 1996 to 2002) alsosuggest that CEO pay-for-firm size elasticity does notdeviate substantially from 0.3, the number reported byRosen (1992). Interestingly, Makinen also finds that theshare of foreign ownership is positively and significantlyassociated with the level of CEO compensation.

2.2. Characteristics for Finnish executive option plans

The first executive stock options were introduced inFinland in the late 1980s, and all option plans were issuedas bonds with warrants, until pure employee stockoptions were allowed in the amendments to the Compa-nies Act in 1997. However, options are still sometimesintroduced as bonds with warrants, typically when thetarget group is broad-based. In one of four cases (35 out of141 during our study period), option plans are granted toa broad group of employees. All other grants are to topexecutives (CEO and top management) only.

The typical time-to-maturity and vesting schedule of astock option plan in Finland corresponds to the design ofsimilar contracts in the US (see, e.g., Murphy, 1999). Theaverage time-to-maturity of the options in our sample is6.16 years and they become ‘vested’ (i.e., exercisable) in oneto five portions (tranches) over a period of about two to fiveyears from the date of the grant. This could mean, forexample, that in each of the last three years before theoptions expire, one-third of the options become exercisable.

Prior to 1993, options in Finland were taxed in asimilar manner to stocks issued to personnel. If the priceat the date of issuance was more than 15% below thecurrent market value, the difference constituted a taxableincome, and it was taxed according to a progressiveincome tax rate. In 1993, a major tax reform distinguishedincome (taxed at a progressive tax rate, which could reacha maximum of 60% at the margin) from capital gains(taxed at a lower flat rate). Stock options were treated ascapital gains and taxed at a flat rate of 25%. However,




from September 1994 onwards, option income was trea-ted as salary and taxed at the higher income tax rate.Income is calculated as the difference between the marketprice and the exercise price at the time of exercise, oralternatively, using the selling price of the option. This taxtreatment has led to the common practice of selling theshares obtained through the option exercise almostimmediately after the exercise to ensure liquidity to payfor heavy income tax. No tax is carried at the grant date.The option-granting firm has to pay a social securityexpense of approximately 5% of the income received bythe option holders from the options, and this expense isdeductible from corporate tax. However, the cost ofgranting options is not deductible for the firm. In thissense, the Finnish tax setting resembles that of Canada(see, e.g., Klassen and Mawani, 2000), where employersare disallowed tax deductions and income statementdeductions related to option compensation.

8 We calculate the value of stock options using the model of Merton

3. Hypothesis development and research design

Compensation theory suggests that the principal’sability to observe the agent’s actions determines the formof compensation. If the appropriate actions are knownand observable, the optimal incentive contract pays theagent (manager) a fixed salary and penalizes her forsuboptimal behavior. However, if managerial actions areat least partly unobservable, tying managerial compensa-tion to productive outcomes (such as firm value) isnecessary to induce the manager to behave optimally(Holmstrom, 1979).

The ability of shareholders to observe and evaluate theactions undertaken by managers is affected by the com-plexity of managerial tasks. When the decisions requiredfrom managers are more complex, it is more difficult forshareholders to monitor these decisions. Consequently,theory suggests that proxies for monitoring cost, such asfirm size, asset complexity, and growth opportunities,should be related to the amount of the equity-basedcompensation and to the power of the incentives that thecompensation provides (see, e.g., Demsetz and Lehn, 1985;Milgrom and Roberts, 1992). This prediction has gainedstrong support in empirical work.7 More recently, however,the optimal contracting literature has been questioned byauthors who suggest that the form and design of executivecompensation is determined by managerial power and theextraction of rents (Bebchuk, Fried, and Walker, 2002). Tocontrast and test these theories, we employ as determi-nants variables from both the optimal contracting litera-ture and the managerial power literature.

The following subsections discuss the hypothesizedrelations between firm characteristics and stock optioncontract design. First, in Sections 3.1 and 3.2, we discuss

7 For example, Baker and Hall (2004) and Himmelberg, Hubbard,

and Palia (1999) show that the value of equity incentives increases at a

decreasing rate with firm size. Furthermore, the findings of Smith and

Watts (1992), Gaver and Gaver (1993), Mehran (1995), Guay (1999),

Himmelberg, Hubbard, and Palia (1999), and Palia (2001) lend support

to a positive relationship between growth or investment opportunities

and equity incentives.


the expected relations between firm attributes and thescope of stock option plans or the exercise price of stockoptions. Second, in Section 3.3, we present and motivatesome additional tests.

3.1. The scope of stock option plans

Our dependent variable is the relative size of the stockoption plan. We first measure this variable by the stock option

overhang (dilution), that is, the fraction of equity obtainedupon the exercise of all granted stock options. Second, wemeasure the scope as the BS value to MV of equity, that is, theBlack-Scholes value of the plan divided by the market valueof equity at the grant date.8 See Appendix A for a detaileddescription of the calculation of the variables.

Under the optimal contracting hypothesis, the firm(the board/compensation committee and, ultimately, theshareholders) designs compensation arrangements exclu-sively for the purpose of alleviating the agency problembetween shareholders and managers (see, e.g., Ross, 1973;Holmstrom, 1979; Grossman and Hart, 1983; Milgromand Roberts, 1992). Hence, under this approach, weexpect a negative relation between CEO ownership andthe scope of stock option plans because direct shareownership may be treated as a substitute for stock optioncompensation. In contrast, under the managerial rentextraction hypothesis of Bebchuk, Fried, and Walker(2002), part of the agency problem is that executivesuse their compensation to provide themselves with rents(i.e., payments in excess of those under a contract thatmaximizes shareholder value). Because CEO ownershipmeasures the direct voting power of the CEO, it isplausible to expect a positive relation between CEO own-ership and the scope of stock option plans under themanagerial rent extraction hypothesis.

Based on two arguments, ownership control can benegatively related to the scope of the stock option plans.First, if concentrated ownership leads to more efficientmonitoring of the management, the need for equity-basedcompensation should be reduced. Furthermore, owner-ship concentration is assumed to be inversely related tomanagerial power and should therefore reduce possibili-ties for managerial rent extraction. Because in Finlandstate ownership is high in some firms and because thestate as an owner can potentially monitor in a differentmanner than other owners, we measure non-state andstate ownership separately. We expect Non-state owner-

ship control to be negatively related to the scope of thestock option plans.

Among the non-state holders, institutional owners canbe viewed as more professional shareholders. Professional

(1973), i.e., modified for dividend payments, for stock options not

protected against dividend payments. For stock option grants specifi-

cally protected against dividend payments, we employ standard Black

and Scholes (1973) methodology. Further, to adjust for the fact that

managers may not be able to fully hedge their holdings (a central

assumption in Black-Scholes valuation), and that the firm may take this

into account when designing their option programs, we also recalculate

the Black-Scholes values using the method suggested by Meulbroek

(2001) for a fully undiversified manager.



10 The key question is how a CEO’s productivity is related to firm

value; it may be through a constant monetary effect irrespective of firm

size or on a proportional basis. This discussion is related to that in


shareholders are expected to have an articulated interestin developing corporate governance mechanisms, whichmay result in a positive relation between Institutional

ownership and the scope of the stock option plan. Incontrast, managerial power is expected to be decreasingin institutional ownership, thus supporting a negativerelation for this variable.

An interesting institutional detail in Finland (unavail-able for examination in the US) is State ownership. Ininternational studies, state ownership is often consideredas a weak form of governance [see, e.g., Shleifer andVishny (1997) for a discussion of problems with stateownership]. In Finland, fear of loose governance in state-controlled firms has led to the creation of governmentownership units that manage the role of the state as ashareholder. Empirical studies9 indicate that compensa-tion in Finnish firms with state ownership does notexceed compensation in other Finnish firms, and thatoption programs in Finnish state-owned firms are morerestrictive. The likely cause of these features is high publicscrutiny in Finland concerning top management salaries,which are disclosed through public tax records andtypically considered to be too high by the media and thepublic. This may lead the government to enact policies toensure that state-owned firms are not exceptional topublic expectations in this respect. Hence, we expect anegative relation between state ownership and the scopeof the stock option plan in our data set.

The expected sign for firm size is more ambiguous. Onecan approach this question both from the agency (mon-itoring) perspective and from the perspective of optimalcompensation theory (free of agency costs). From theagency point of view, Jensen and Meckling (1976) arguethat large firms are more difficult (costly) to monitor,which would motivate greater equity incentives in largefirms. Also, e.g., Demsetz and Lehn (1985) hypothesizethat the level of managerial equity holdings should begreater in larger firms. However, other authors takedifferent views on this relation. Schaefer (1998) reportsan inverse relation between pay-performance sensitivity(measured on a ‘‘dollar-to-dollar’’ basis) and firm size.Because grant size (together with delta) is a component ofpay-performance sensitivity, this result might imply anegative relation between the scope of option plans andfirm size. Baker and Hall (2004) obtain results in line withSchaefer’s (using a similar measure), but they also showthat when changes in the CEO’s wealth are related topercentage changes in firm value (instead of absolute

9 See, e.g., Hansson, Liljeblom, Loflund, Maury, Pasternack, and

Rosenberg (2002), who study option programs in listed firms from

1989 to 2000, and Ikaheimo, Kontu, Kostiander, Tainio and Uusitalo

(2007), who use compensation and interview data for 2001 to 2005.

Hansson, Liljeblom, Loflund, Maury, Pasternack, and Rosenberg (2002)

find that the option programs in state-controlled firms were smaller in

scope and with regards to the incentives given by them. Ikaheimo,

Kontu, Kostiander, Tainio, and Uusitalo (2007) in turn conclude that the

compensation structure in Finnish firms with state ownership was

similar to that in other Finnish firms. Controlling for sector and year,

the ability of state-owned firms to generate shareholder value was very

similar to that of other Finnish firms, although somewhat more stable.


changes), the relation to size is strongly positive.10 They alsoestimate the elasticity of the CEO’s marginal product withrespect to firm size and obtain an estimate of about 0.4; thatis, they find that CEO marginal products rise strongly, butnot proportionally/not linearily in absolute terms with firmsize. In our model, we use a proportionate (relative) optionplan scope variable (relative to the equity of the firm). If CEOproductivity rises proportionally with firm size and equity(given unchanged leverage) and if compensation followsproportionally, our (relative) measure of scope will remainconstant and therefore be independent of any measure offirm size. However, if CEO productivity rises less thanproportionately with firm size, as argued by Baker andHall (2004), a negative relation will follow.

Theory and prior empirical evidence suggests thatequity-based compensation is positively related to firmgrowth opportunities. This suggests a positive relationbetween the scope of stock option plans and both Tobin’sQ and investment intensity, which is measured as Invest-

ment-to-capital. However, several prior studies (see, e.g.,Morck, Shleifer, and Vishny, 1988) employ Tobin’s Q as ameasure of firm performance. If one assumes that theexpected marginal benefits of equity-based compensationare decreasing in firm performance (if, on average, better-performing firms are already closer to the optimal level ofmanagerial compensation, and enjoy the benefits of close tomaximal managerial effort), then the shareholders of well-performing firms may be less willing to provide additionallarge equity incentives because their costs, given risk-aversemanagers already owning firm stock, may exceed thebenefits.11 This would result in a negative relation betweenscope on the one hand and Tobin’s Q and profitability(measured as the ratio of Cash flow- to-assets) on the other.

We also include a measure of financial leverage (Long-

term debt-to-assets) and expect a negative relation betweenfinancial leverage and the scope of stock option plans.Jensen’s (1986, 1993) arguments imply that the disciplinaryrole of debt may reduce agency costs, in which case firmswith high financial leverage have a reduced need for equityincentives as a control mechanism.12 We include theCapital-to-sales ratio and Firm focus to measure monitoringcomplexity and expect a negative relation between bothvariables and the scope of stock option plans.13 In addition,

Holmstrom’s (1992) two models of pay sensitivity, of which he prefers

the proportionate one, partly due to its better fit with the data.11 Of course, well-performing firms also need to periodically renew

their incentives, which at least partly dampens this argumentation.12 Furthermore, John and John (1993) analyze the relation between

firms’ compensation policies and capital structure and predict that highly

levered firms will provide less equity incentives to motivate optimal choices

regarding managerial risk. The intuition of this argument is straightforward,

i.e., if managers have strong incentives to increase the value of equity,

creditors will demand higher risk premia for providing capital (debt) for fear

that managers will pursue high-risk strategies, transferring wealth from

creditors to shareholders (the asset substitution problem).13 Empirical work has shown that firm diversification destroys value

and results in the well-known diversification discount. The dominant

part of the explanations for the diversification discount suggests that

agency costs can be expected to be higher in diversified firms, which in




we further decompose the variable measuring firm focusinto Mature industry and Growth industry indicators becausewe expect to find differences in the use of equity incentivesbetween these groups. See Table 2, Panel C for detailsconcerning which industries are classified as mature vs.growth industries.

Firm risk is included to measure monitoring difficultyas a result of noisiness in the firm’s operating environ-ment (Demsetz and Lehn, 1985) and of the extent towhich risk-averse managers can be incentivized via stockand option holdings (see, e.g., Himmelberg, Hubbard, andPalia, 1999). The expected relation between firm risk andthe scope of stock option plans is thus subject to ambi-guity. In empirical work, Jin (2002) finds that executivepay becomes less sensitive to performance as unsyste-matic risk increases but finds no relation between sys-tematic risk and pay-for-performance. We thus alsoexamine whether the type of risk affects the relation bydecomposing Total risk into Systematic risk and Unsyste-

matic risk components.We also include indicator variables for a Prior plan in

effect and a Broad-based plan. We expect a smaller scopeof stock option plans if a prior plan is in effect. A broad-based plan is expected to have a greater scope because thetarget group of the plan is assumed to be larger. Further-more, we include a dummy for a Dividend-protected plan

and performance-vested/indexed plans (PV/indexed plan)to control for the effect of unconventional contract designfeatures. Finally, year indicator variables are included tocontrol for time effects.

Based on the above discussion, our model for thedeterminants of the scope of the option plan is:

Scope of stock option plan¼ f ½CEO ownership ð7Þ,

Non-stateownership controlð�Þ, Institutionalownership ð7 Þ,

State ownership ð�Þ, Firm size ð�Þ, Tobin’s Q ð7 Þ,

Investment to capital ðþÞ,Cash flow to assets ð�Þ,

Long-term debt to assets ð�Þ, Capital to sales ð�Þ,

Firm focus ð�Þ, Risk ðas Total risk, Systematic risk,

or Unsystematic riskÞ ð7Þ, Prior plan in effect ð�Þ,

Broad-based plan ðþÞ, Dividend-protected plan ð?Þ,

PV=indexed plan ð?Þ�: ð1Þ

Appendix B provides a summary of our expected signsas well as the categories of theories from which they arederived.

3.2. The exercise price of stock options

Determinants of the second main design attribute ofstock option plans, the setting of the exercise price, areinvestigated by a similar model as in the case of the scopeof stock option plans. The empirical model is thus as

(footnote continued)

turn could be explained by the fact that the monitoring of the manager’s

effort is more costly in diversified firms compared to focused firms. See,

e.g., Lamont and Polk (2001) for a review of the causes and conse-

quences of diversification.


follows:

Stock option premium¼ f ½CEO ownership ð�Þ,

Non-stateownership controlðþÞ, Institutional ownership

ðþÞ, State ownership ðþÞ, Firm size ð?Þ, Tobin’s Q ð�Þ,

Investment to capitalð�Þ, Cash flow to

assets ð�Þ, Long�term debt to assets ð�Þ,

Prior stock returnð�Þ, Capital to salesðþÞ,

Firm focus ðþÞ, Risk ðas Total risk, Systematic risk,

or Unsystematic riskÞ ð7Þ, Prior plan in effect ð?Þ,

Broad-based plan ð?Þ, Dividend-protected planðþÞ,

PV=indexed plan ð�Þ�: ð2Þ

Again, Appendix B provides a summary of ourexpected signs and the categories of the theories fromwhich they are derived. Our dependent variable, the stockoption premium (out-of-the-moneyness), is defined as[(X�S)/S], where X corresponds to the exercise price ofthe option, and where S is the stock price at the grantdate. We use two different specifications of the dependentvariable: (i) the First tranche premium, which is calculatedas the out-of-the-moneyness of the options belonging tothe first tranche in the corresponding option plan, and (ii)the Weighted average premium, which utilizes informationon the characteristics of the total option plan. The weightsused in the calculation correspond to the ratio of thenumber of shares obtainable upon exercise in eachindividual stock option tranche divided by the totalnumber of shares obtainable upon exercise of all stockoptions. See Appendix A for a detailed description of theprocedure used to calculate the stock option premium.

In Eq. (2) for the premium, most of the explanatoryvariables are the same as in Eq. (1) and often have similarinterpretations in terms of the effects they proxy. How-ever, because the dependent variables in (1) and (2) areopposite in the sense that a larger scope is related to ahigher level of compensation, while a higher premium (ahigher out-of-the-moneyness) means a lower option andcompensation value, the expected signs for the explana-tory variables are typically opposite to those in Eq. (1). Wetherefore expect, for example, that greater managerialpower (higher CEO ownership, and, correspondingly, lowerNon-state ownership control, Institutional ownership, andState ownership) is negatively related to the stock optionpremium. A greater degree of power enjoyed by managersmay lead to more potential benefits that they can extractat the expense of shareholders.

Firm size has an ambiguous expected impact on optionpremium from a theoretical point of view but is includedas a control variable. Tobin’s Q and firm profitability (Cash

flow-to-assets) have an expected negative relation withthe stock option premium because we expect that firms(shareholders) with lower profitability (reflected in thestock price) require greater stock price appreciation toaward managers. Further, we expect investment intensity(Investment-to-capital) and leverage (Long-term debt-to-

assets) to be negatively related to the stock optionpremium. Choe (2003) shows that, all other things beingequal, the optimal exercise price of stock options is




decreasing in the riskiness of the firm’s desired invest-ment policy and in the degree of financial leverage. Morespecifically, Choe (2003) argues that greater financialleverage reduces the exercise value of stock options,which leads to the need to perform a downward adjust-ment on the exercise price, if other components ofexecutive compensation are fixed. In other words, higherleverage encourages managers to take more risk (assetsubstitution), which needs to be mitigated through lowerexercise prices of stock options.

We expect Prior stock return to be inversely related to thestock option premium. Two alternative hypotheses couldproduce such a relation. First, firms (shareholders) mightrespond to poor prior stock price performance by requiringa higher corresponding stock price appreciation to rewardmanagers. This would be in line with the idea that ownershave a high-water mark contract in mind, i.e., after fallingstock prices, they expect a recovery up to a certain pointbefore rewarding managers for the additional upside.14 Thisexplanation would be in line with optimal contracting. Analternative explanation, following the managerial rentextraction hypothesis, is that the ability of the manager tonegotiate favorable compensation arrangements shouldincrease following a stock price appreciation. If Tobin’s Q

(which also is dependent on stock price) is viewed as aproxy for profitability, the same negative relation with thestock option premium as for Prior stock return might beexpected, with the same two alternative arguments asabove. Additionally, when Cash flow-to-assets proxy profit-ability, the managerial rent extraction hypothesis mayapply, which would indicate a negative expected signbecause the managerial power to negotiate favorable con-tracts might be higher in more profitable firms.

The Capital-to-sales ratio, Firm focus, and firm risk areused to proxy monitoring difficulty/costs. Yermack (1997)argues that firms may want to award discount stockoptions with in-the-money exercise prices to achieve alarger pay-for-performance sensitivity than provided byat-the-money, fair market value stock options. On ashare-for-share basis, discount stock options providehigher pay-for-performance sensitivities than do fairmarket value stock options (Lambert, Larcker, andVerrecchia, 1991). Furthermore, this result may be gen-eralized regarding the exercise price of the stock options,that is, a higher out-of-the-moneyness of the stock optionindicates a lower degree of pay for performance, all otherthings being equal. Consistent with principal-agent the-ory, we expect that firms with a higher degree of mon-itoring costs design compensation structures to providegreater pay-for-performance. The relation between the

14 Since manager compensation consists of a combination of a fixed

fee and a variable part (bonus plus executive options), especially the

option part might be considered as compensation for extraordinary

manager skill. Goetzmann, Ingersoll, and Ross (2003) characterize high-

water mark contracts as pure bets on manager skill, and it limits the

value of performance fees. Their analysis of the relative benefits of

different fee structures in hedge fund industries suggests that high

variance strategies lend themselves to high-water mark contracting. In

our case, the analogy would be that especially in high volatility

industries, a high-water mark type of compensation contract might be

optimal.


stock option premium and both the capital-to-sales ratioand firm focus (which, when higher, proxy lower mon-itoring costs) is expected to be positive, whereas therelation between the premium and firm risk (total risk,systematic risk, and unsystematic risk) is, as before,subject to ambiguity since risk may proxy both monitor-ing difficulty as well as the extent to which risk-aversemanagers can be incentivized. As mentioned previously,Jin (2002) finds a negative relation between the level ofunsystematic risk and pay-for-performance but fails tofind a significant relation between systematic risk andpay-for-performance. For the option premium, there is anadditional possible explanation, also under optimal con-tracting: high-water mark features may be includedespecially in high volatility industries. That would indi-cate a positive relation between firm risk and the optionpremium.

Further, in a similar manner as for the scope of stockoption plans in Eq. (1), we examine whether the premiumdiffers for firms operating in Mature and Growth indus-tries. Furthermore, we control for the existence of a Prior

plan in effect, whether the plan is a Broad-based plan, aDividend-protected plan, or a performance-vested/indexedplan (PV/indexed plan). The first two variables haveambiguous expected relations with the stock optionpremium. For dividend-protected stock options we expecta higher premium, whereas for performance-vested/indexed stock options we expect a lower premium. Thisis because the expected value of the stock option is higherin the case of dividend protection and lower in the case ofperformance-vesting/indexing, all other things beingequal. As for the scope of stock option plans, we controlfor time effects by including year indicator variables.

3.3. Additional tests regarding scope and exercise prices

The empirical analysis in this paper concentrates onthe two main design attributes of stock option plans,namely, the relative size of stock option plans (scope), andthe exercise price. These attributes are chosen becausethey are the main consideration of the ultimate compen-sation providers, that is, the shareholders of the firm, inevaluating and approving compensation proposals. How-ever, because the design of stock option plans containstwo main elements, that is, (i) the dilution of existingequity holders and (ii) the price at which stock may bepurchased, it is straightforward to assume that theseattributes are simultaneously determined. A trade-offexists between dilution and the associated premium.Therefore, to allow for the possibility that the scope andpremium of stock option plans are determined simulta-neously, we perform a simultaneous equation analysisusing three-stage least squares (3SLS), with the scope andpremium as endogenous variables. In particular, Eqs. (1)and (2) are estimated concurrently. In this analysis, wefocus on the specifications of the variables that areexpected to be the most critical elements, specifically,the stock option overhang and the (weighted) averagepremium of the stock option plan.

Furthermore, we extend the analysis of the dynamicsof the stock option premium by estimating two categories




of discrete decision models. Yermack (1997) argues that iffirms really do give extensive thought to the optimalexercise prices of executive options, one should expect anontrivial fraction of options to be awarded out-of-the-money. However, the literature shows that these pre-mium options are extremely rare in the US, whichremains a puzzle. In Finland, the data show that anontrivial amount of stock options are awarded without-of-the-money exercise prices. The Finnish settingthus offers an interesting laboratory to test the factorsassociated with granting premium (out-of-the-money)stock options. As a result, in the first category, weconstruct dependent variables that take the value of oneif (i) the first tranche premium is positive and zerootherwise, and (ii) the weighted average premium ispositive and zero otherwise. Furthermore, to provideadditional insights into the factors that drive awards ofpremium stock options, we include an additional restric-tion in the construction of the dependent variables. In thesecond category, we construct dependent variables thattake the value of one if (i) the first tranche premium ispositive and the stock option plan is targeted solely to thetop management of the firm and zero otherwise, and (ii)the weighted average premium is positive for stockoptions targeted to top management and zero otherwise.

Finally, we also test for the relation between the lengthof the vesting period and the size of the premium to testfor whether – in line with optimal contracting – theshareholders grant more out-of-the money options whentheir vesting period is further in the future. This view iscontradictory to that of Bebchuk, Fried, and Walker (2002).

4. Sample characteristics

This section first gives details of the Finnish market interms of corporate governance, business culture/share-holder orientation, and executive compensation. Next, thedata sources used in the paper are described. Sampleselection issues are also discussed here. Finally, a descrip-tive analysis of the data is presented.

4.1. Data sources and sample selection

In Finland, executive stock option plans (ESOPs) forlisted companies have to be approved by a shareholders’meeting, usually the Annual General Meeting (AGM). TheAGM typically approves both the scope of the plan(number of options) and the conditions for setting theexercise prices and vesting periods for the differenttranches of the program. This is unique; in other countriesdecisions concerning contract details are typically left tothe board/compensation committee (see, e.g., Rosser andCanil, 2004). In Finland, after the AGM approves of theplan, the company board then decides, with the help of itscompensation committee (which consists of some inde-pendent board members and excludes the CEO), thestructure of the CEO’s compensation package and partici-pates in setting the general guidelines for the firm’scompensation policies. Alexander Corporate Finance Oyhas been a dominant consultant of companies in Finlandregarding ESOPs and thus has a unique data set of all of


the plans and their specific tranches. They also havecomplemented their data set with information on thefew programs of listed firms that were not consulted byAlexander Corporate Finance Oy. Our data set, which wasreceived from Alexander Corporate Finance Oy, thusincludes all stock option plans for all Finnish-listed firmsduring the time period of 1987–2001. The data containinformation regarding the introduction date of stockoption plans, the target group, vesting periods and con-tract maturities, the exercise prices, the number of sharesobtainable upon exercise of stock options, and whetherthe stock options are subject to dividend protection and/or performance-vesting/indexing.

Firm accounting data are obtained from the ResearchInstitute of the Finnish Economy (ETLA). Firm ownershipdata are obtained from Porssiyhtiot manuals and theFinnish Central Securities Depository (FCSD). Stockreturns, interest rates, and data regarding the number ofoutstanding shares are obtained from the Hanken Schoolof Economics (Hanken). Stock prices and dividends arecollected from DataStream and Hanken’s database.

The raw sample covers the time period of 1987–2001and consists of all public stock option plans in Finlandsince the first plan was introduced in 1987 (287 stockoption plans). The current study is restricted to firms thattrade on the main list of the Helsinki Stock Exchange(HEX), with banks and insurance companies excluded fromthe analysis. The initial sample is created by identifyingstock option plans for firms that have appeared on themain list of HEX during the investigation period (thepresence of a trading code in Hanken’s database). Firmsmay have launched several stock option plans during thesame year, and in these cases, we include only the firststock option plan that was launched during the year in theanalysis. To calculate the total Black-Scholes option valueof the stock option plans, we require a minimum of 60daily stock returns prior to the grant date, which excludes47 stock option plans from the analysis. The excluded plansare those that were launched while the firm was listed onother than the main list of HEX or that were launched indirect connection with the firm’s initial public offering(IPO) to the main list of HEX. Furthermore, to calculateexplanatory risk variables, we require a minimum of 60daily stock returns prior to the end of the last accountingperiod preceding the launch of the stock option plans,which excludes an additional 13 stock option plans fromthe analysis. This procedure results in a final sample of 141stock option plans for the period of 1987–2001, whichrepresents approximately 49% of the total number of stockoption plans introduced in Finland. Table 1 presents thesample selection procedure used in the study.

Table 2 presents sample characteristics, divided intoPanel A (plan characteristics), Panel B (timing of stock optionplans), and Panel C (industry distribution). Of the 141 stockoption plans included in the sample, 106 (75%) were targetedto the top management of the firm, whereas 35 (25%) stockoption plans were also targeted to non-executive employees(broad-based stock option plans). Dividend protection isincluded in 71 (50%) of the 141 stock option plans in thestudy. Finally, of the sample stock option plans, 12 (9%)involved performance-vesting/indexing, whereas 129 (91%)



Table 1Sample selection.

The raw sample covers the time period 1987–2001 and consists of all

stock option plans introduced in Finland (287 stock option plans). The

current study is restricted to firms trading on the main list of the

Helsinki Stock Exchange (HEX), with banks and insurance companies

excluded from the analysis. Firms may have launched several stock

option plans during the same year, and in these cases, we include only

the initially launched stock option plan during the year in the analysis.

The sample selection procedure results in a final sample of 141 stock

option plans during the years 1987–2001, which represents approxi-

mately 49% of the total number of stock option plans introduced in

Finland.

Sample selection

Total number of stock option plans in Finland (1987–2001) 287

Firms appearing on HEX main list during the sample period

(SSEBA-HEX code available)

226

Firms that have not appeared on HEX main list during the

sample period (I- or NM-lists: no SSEBA-HEX code available)

61

Total 287

Initial sample 1 226

Banks or insurance companies (HEX main list) 17

Multiple grants during year (HEX main list) 8


Lack of stock return history (a minimum of 60 daily

observations from grant date backwards) for Black and

Scholes option valuation

47

Firms may have launched stock option plans during listing on

other lists than HEX main list (years before listing on HEX

main list) or directly in connection with IPO to HEX main list


Lack of stock return history (a minimum of 60 daily

observations backwards from the last accounting period end

before grant date) for explanatory risk variables

13

Final sample (number of stock option plans) 141

Percentage of all stock option plans in Finland (1987–2001) 49%


stock option plans were traditional plans. In Finland, perfor-mance-vesting typically implies that the exercise of stockoptions is conditional on whether some accounting-basedmeasure of firm performance is fulfilled (e.g., net profit).Indexing of stock options refers to the policy that theexercise price of stock options is determined relative to, forexample, a peer-group benchmark. Table 2 shows the timingof the stock option plans in the sample (introductions andfollow-up plans). As can be seen from Table 2, the majorityof stock option plans were granted in the latter half of the1990s.15

Finally, Table 2 also presents the distribution of stockoption plans across industries. The industry classificationsare obtained from the accounting data of ETLA. Theindustry is defined by ETLA as the area where at least60% of annual sales are generated; otherwise, the firm isclassified as multi-business (diversified). Of the stockoption plans in the sample, 30 (21%) were granted bydiversified firms. Additionally, we divided the firms in the

15 Anecdotal evidence suggests that this phenomenon is driven by

factors such as the abolishment of restricting foreign ownership in

Finnish publicly traded firms in 1993, joining the European Monetary

Union (EMU), accompanied by the introduction of the euro in 1999, and

the favorable development of stock market valuations in the late 1990s.


focused category into mature and growth industries. Thestatistics in Table 2 reveal that 72 (51%) of the stockoptions plans in the sample were granted by firms inmature industries, whereas 39 (28%) stock options werelaunched by firms in growth industries. The median valueof Tobin’s Q for diversified firms, mature firms, andgrowth firms is 1.113, 1.099, and 2.678, respectively.

4.2. Descriptive statistics

Table 3 provides a descriptive analysis of the data. Thestatistics for the scope of stock option plans indicate thatthe average value for the stock option overhang (dilution)is 3.2% and that the average value of the total Black-Scholesvalue divided by the market value of equity is 1.4%. Asmentioned earlier, the stock option overhang measures thefraction of equity ownership that would result from theexercise of all stock options. Furthermore, the values forthe stock option premium (out-of-the-moneyness) indicatethat the stock option plans in the sample have, on average,been granted out-of-the-money. The average value for thefirst tranche premium is 10.4% and the weighted averagepremium is 11.2%, on average. The first tranche premium ispositive (out-of-the-money) in 69% of the sampled stockoption plans, zero (at-the-money) in 11% of the sampledstock option plans, and negative (in-the-money) in 20% ofthe sampled stock option plans. The corresponding figuresfor the weighted average premium are 70% (out-of-the-money), 11% (at-the-money), and 19% (in-the-money).

5. Empirical results

This section presents and discusses the empirical results.First, we report and discuss the results regarding thedeterminants of the scope, and the exercise price of stockoptions, in Sections 5.1 and 5.2, respectively. We then reportresults from further specification tests in Section 5.3.

5.1. Determinants of the scope of stock option plans

Table 4 presents regression results regarding the rela-tions between firm attributes and the scope of stockoption plans. Panel A presents results from the regres-sions where the scope of stock option plans is measuredas Stock option overhang, that is, the fraction of equityobtained upon exercise of all granted stock options. PanelA also reports results from four different specifications:specifications [I] and [II] employ a measure of total firmrisk and specifications [III] and [IV] decompose total firmrisk into systematic and unsystematic components. Spe-cifications [I] and [III] include an indicator variable forfirm focus, whereas specifications [II] and [IV] decomposethis indicator variable into separate variables for matureand growth industries.16

16 Instead of the indicator variables for mature and growth indus-

tries, we re-estimated the models using dummies for seven industries.

The results were unaffected by this change. Also, the latter models were

re-estimated using industry dummies, without any significant effects on

results.



Table 2Sample characteristics.

The sample covers the time period 1987–2001 and consists of stock option plans launched by firms traded on the main list of the Helsinki Stock

Exchange (HEX). Panel A. [1] displays the distribution of the target group of stock option plans. Stock option plans are defined as targeted top

management if stock options are targeted solely to the top management of the firm. If stock options are also targeted to non-executive employees, the

stock option plan is defined as being broad-based. Panel A. [2] presents the distribution of dividend protection in connection with stock option plans. In

dividend-protected stock option plans, exercise prices are adjusted (reduced) on the ex-dividend date for the amount of dividend payments per share.

Panel A. [3] shows the distribution of performance-vested/indexed stock option plans in the sample. A stock option plan is defined as performance-

vested/indexed if the exercise of stock options is conditional on whether some accounting-based measure of firm performance is fulfilled (e.g., net profit),

and/or whether the exercise price is determined relative to, e.g., a peer-group benchmark.

Panel A: Plan characteristics

A. [1] Target group A. [2] Dividend protection A. [3] Performance-vesting/indexing

Top management plans 106 (75%) Included 71 (50%) Included 12 (9%)

Broad-based plans 35 (25%) Not included 70 (50%) Not included 129 (91%)

Total 141 Total 141 Total 141

Panel B: Timing of stock option plans

B. [1] Introductions B. [2] Follow-up contracts B. [3] New stock option plans

1987 1 1987 0 1987 1

1988 2 1988 0 1988 2

1989 3 1989 2 1989 5

1990 1 1990 1 1990 2

1991 0 1991 2 1991 2

1992 1 1992 0 1992 1

1993 4 1993 1 1993 5

1994 12 1994 2 1994 14

1995 2 1995 2 1995 4

1996 2 1996 4 1996 6

1997 5 1997 11 1997 16

1998 7 1998 15 1998 22

1999 3 1999 11 1999 14

2000 6 2000 21 2000 27

2001 1 2001 19 2001 20

Total 50 91 141

Panel C: Industry distribution

Chemical and plastic [M] 9 (6%) Foods [M] 10 (7%) Retail [M] 3 (2%)

Construction [M] 5 (4%) Forest [M] 8 (6%) Services [M] 1 (1%)

Diversified [D] 30 (21%) Information technology [G] 13 (9%) Telecommunications [G] 3 (2%)

Electricity and electronical equipment [G] 7 (5%) Investment [G] 5 (4%) Textile [M] 3 (2%)

Electronical equipment [G] 7 (5%) Media [G] 4 (3%) Transportation [M] 6 (4%)

Energy [M] 1 (1%) Metal [M] 20 (14%) Wholesale [M] 6 (4%)

Diversified [D] 30 21%

Mature industry [M] 72 51%

Growth industry [G] 39 28%

Total 141 100%


The results reported in Panel A reveal that the variablesthat measure the ownership structure of the firm generallydo not seem to be associated with the scope (stock optionoverhang) of stock option plans. The coefficients for Tobin’s

Q are negative and significant at the 1% level in all fourspecifications. As mentioned earlier, the predicted relationbetween Tobin’s Q and the scope of stock option plans isambiguous and depends on whether one interprets Tobin’sQ strictly as a proxy for the degree of growth opportunitiesor for firm performance. If it proxies firm performance, theresult is consistent with the view that poorly performingfirms introduce larger stock option plans to enforce incen-tive alignment (i.e., to motivate managers and employeesto maximize shareholder value).

The coefficient for Capital-to-sales is negative and system-atically highly significant at the 1% level. Furthermore, the


coefficients for Total risk are positive and significant at the 5%level. These results are in line with predictions from optimalcontracting theory, that is, consistent with the argument thatfirms with a high degree of monitoring difficulty/costs (a lowratio of capital-to-sales and high variation in expected cashflows) use greater equity incentives. Finally, the coefficientsfor Broad-based plan and Dividend-protected plan are positiveand significant at the 1% level in all specifications. Althoughseveral coefficients in Panel A exhibit statistical significance,it is noteworthy that the economic significance of severalvariables tends to be small.

Panels B and C display the results of the regression wherethe scope of the stock option plan is measured as the ratio ofthe total Black-Scholes value (Panel B) or the total AdjustedBlack-Scholes value (Panel C) to the market value of thefirm’s equity. Results for two different specifications are



Table 3Descriptive statistics.

The sample covers the time period 1987–2001 and consists of firms traded on the main list of the Helsinki Stock Exchange (HEX). The table presents

summary statistics for the full sample. Stock option overhang is calculated as the total number of shares exercisable induced by the stock option plan

divided by the sum of the total number of shares exercisable and the number of shares outstanding at the grant date. Stock options are valued using the

Black-Scholes (1973) methodology adjusted for dividend payments as in Merton (1973). Stock options specifically protected against dividend payments

are valued using standard Black-Scholes methodology. The stock option premium (out-of-the-moneyness) is defined as [(X�S)/S], where X corresponds

to the exercise price of the option and where S is the stock price at the grant date. The first-tranche stock option premium is calculated as the out-of-the-

moneyness of the stock options belonging to the first tranche in the stock option plan. The weighted average stock option premium utilizes information

of the characteristics of the total stock option plan. The weights used in the calculation correspond to the ratio of the number of shares obtainable upon

exercise in each individual stock option tranche divided by the total number of shares obtainable upon exercise of all stock options. Data on foreign

ownership are only available from the Finnish Central Securities Depositary (FCSD) from October 1993 onwards, and due to this, data on foreign

ownership are missing in 24 observations. Complete data on prior stock returns are missing in four observations. All risk measures are multiplied by 100.

See Appendix A for a definition of variables.

Variable Mean Median Std. dev. 1st Quart. 3rd Quart. Minimum Maximum

Number of observations [141]

Stock option plan characteristicsStock option overhang [shares exercisable/(shares

exercisableþshares outstanding)]

0.032 0.026 0.023 0.017 0.045 0.001 0.108

Total Black and Scholes value of option plan [h] 45,389,440 3,024,407 278,188,950 1,346,701 8,726,311 3,315 2,958�106

Total Black and Scholes value of option plan to

market value of equity

0.014 0.009 0.014 0.004 0.019 0.000 0.081

Adjusted total Black and Scholes value of option

plan to market value of equity

0.007 0.005 0.006 0.002 0.009 0.000 0.031

First tranche premium [(X�S)/S] 0.104 0.064 0.172 0.000 0.180 �0.251 0.869

Weighted average premium [(X�S)/S] 0.112 0.078 0.178 0.000 0.189 �0.251 0.869

Ownership variablesCEO ownership 0.011 0.000 0.053 0.000 0.000 0.000 0.440

Non-state ownership control 0.316 0.286 0.172 0.172 0.433 0.018 0.799

Institutional ownership [1/0] 0.887

State ownership [1/0] 0.142

Foreign ownership [117 observations] 0.272 0.207 0.235 0.069 0.448 0.001 0.960

Firm characteristicsTotal assets [h000] 1 725 771 586 471 3 526 308 135 559 1 396 000 20 014 21 322 865

Tobin’s Q 2.335 1.202 3.679 0.997 1.973 0.715 30.928

Investment-to-capital 0.274 0.214 0.201 0.128 0.369 0.019 1.011

Long-term debt-to-assets 0.224 0.220 0.144 0.099 0.332 0.001 0.647

Wages per employee 0.207 0.204 0.069 0.161 0.248 0.053 0.446

Zero-dividends [1/0] 0.142

Cash flow-to-assets 0.144 0.126 0.085 0.095 0.170 �0.059 0.462

Free cash flow-to-assets 0.002 0.017 0.127 �0.030 0.067 �0.804 0.300

Prior stock return [137 observations] 0.066 0.057 0.304 �0.120 0.266 �0.818 1.127

Capital-to-sales 0.877 0.433 2.017 0.252 0.682 0.057 13.577

Firm focus [1/0] 0.787

Mature industry [1/0] 0.511

Growth industry [1/0] 0.277

Total risk 0.077 0.056 0.069 0.038 0.094 0.013 0.479

Systematic risk 0.014 0.006 0.025 0.002 0.015 0.000 0.157

Unsystematic risk 0.063 0.048 0.051 0.031 0.078 0.012 0.331

Number of firms 75


reported in both panels. In the first specification [I], a firm-focus indicator variable is included, whereas the secondspecification [II] includes separate variables for mature andgrowth industries. The specifications in Panels B and C do notinclude variables that measure firm risk because dependentvariables (the BS value or the Adjusted BS value, which areboth related to the MV of equity) incorporate the historicalstandard deviation of stock returns in their measurement.

In line with the results in Panel A, Tobin’s Q is alsonegative and significant in Panel C, but not in Panel B.Capital-to-sales and Broad-based plan also obtain theexpected signs in Panels B and C and are again highlysignificant. In Panel B, the coefficient of Dividend-protected

plan is also positive and significant as before, now at the


5% level, but the coefficient is not significant in specifica-tion [III] in Panel C.

The results in Panels B and C differ from those in Panel Ain some respects. Long-term debt-to-assets is now signifi-cant at levels ranging from 1% to 10% in the differentspecifications. This contradicts the view that debt sub-stitutes for equity incentives (Jensen, 1986, 1993) andwith John and John’s (1993) prediction that highly leveredfirms will provide less equity incentives to motivateoptimal managerial risk choices. Both Non-state ownership

control as well as State ownership are significant withexpected signs in Panel C, which indicates that strongerownership control is associated with smaller optiongrants. Also in Panel C, Cash flow-to-assets is significant



Table 4Determinants of the scope of stock option plans.

The stock option overhang in Panel A is measured as the fraction of equity obtained upon exercise of all granted stock options, i.e., as the ratio of the number

of shares exercisable to the sum of shares exercisable and the number of outstanding shares at the date of the grant. In Panel B the scope of the stock option

plan is calculated as the total Black-Scholes value divided by the market value of equity at the grant date. Panel C uses Black-Scholes values adjusted following

the method suggested by Meulbroek (2001) for a fully undiversified manager and divided by the market value of equity at the grant date. The independent

variables are measured at the end of the previous year. A full set of year dummies is included in all specifications (not reported). All risk measures are

multiplied by 100. See Appendix A for variable definitions. Estimation is conducted utilizing OLS. The t-statistics (reported beneath each regression coefficient)

are calculated using robust standard errors. The 1%, 5%, and 10% significance levels are denoted with nnn, nn, and n, respectively. Final sample: Stock option plans

introduced by firms trading on the main list of the Helsinki Stock Exchange (HEX) during the years 1987–2001 (see Table 1).

Independent variables Dependent variable

Panel A: Stock option overhang

[I] [II] [III] [IV]

CEO ownership 0.025n 0.025n 0.022 0.022

(1.73) (1.72) (1.47) (1.46)

Non-state ownership control 0.003 0.003 0.003 0.003

(0.27) (0.27) (0.26) (0.26)

Institutional ownership [1/0] 0.002 0.003 0.003 0.003

(0.36) (0.35) (0.42) (0.42)

State ownership [1/0] �0.007 �0.007 �0.007 �0.007

(�1.35) (�1.36) (�1.37) (�1.38)

Firm size �0.002n�0.002 �0.002n

�0.002n

(�1.66) (�1.63) (�1.74) (�1.73)

Tobin’s Q �0.003nnn�0.003nnn

�0.003nnn�0.003nnn

(�3.82) (�3.76) (�3.72) (�3.77)

Investment-to-capital 0.017 0.017 0.016 0.016

(1.36) (1.37) (1.26) (1.27)

Long-term debt-to-assets 0.016 0.016 0.018 0.018

(1.17) (1.11) (1.25) (1.21)

Cash flow-to-assets 0.030 0.029 0.026 0.026

(1.08) (1.03) (0.95) (0.91)

Capital-to-sales �0.003nnn�0.003nnn

�0.003nnn�0.003nnn

(�3.68) (�3.37) (�3.64) (�3.35)

Firm focus [1/0] �0.003 �0.003

(�0.67) (�0.65)

Mature industry [1/0] �0.003 �0.003

(�0.68) (�0.66)

Growth industry [1/0] �0.002 �0.002

(�0.33) (�0.30)

Total risk 0.081nn 0.081nn

(2.23) (2.18)

Systematic risk 0.155 0.155

(1.21) (1.21)

Unsystematic risk 0.054 0.053

(1.01) (1.01)

Prior plan in effect [1/0] �0.002 �0.002 �0.001 �0.001

(�0.47) (�0.46) (�0.39) (�0.39)

Broad-based plan [1/0] 0.025nnn 0.024nnn 0.025nnn 0.025nnn

(5.37) (5.07) (5.45) (5.12)

Dividend-protected plan [1/0] 0.011nnn 0.011nnn 0.012nnn 0.012nnn

(2.86) (2.88) (2.87) (2.90)

PV/indexed plan [1/0] �0.0004 �0.0004 �0.0004 �0.0004

(�0.09) (�0.09) (�0.08) (�0.08)

Year dummies Yes Yes Yes Yes

Adjusted R-squared 0.488 0.483 0.486 0.481

Number of observations 141 141 141 141

Dependent variable

Panel B: BS value to MV of equity Panel C: Adjusted BS value to MV of equity

[I] [II] [III] [IV]

CEO ownership 0.004 0.006 0.001 0.003

(0.44) (0.59) (0.24) (0.51)

Non-state ownership control �0.001 �0.001 �0.005n�0.005n

(�0.14) (�0.11) (�1.77) (�1.84)

Institutional ownership [1/0] �0.004 �0.003 �0.0001 0.0011

(�0.83) (�0.63) (�0.05) (0.66)

Please cite this article as: Liljeblom, E., et al., What determines stock option contract design? Journal of FinancialEconomics (2011), doi:10.1016/j.jfineco.2011.02.021



Table 4 (continued )

Dependent variable

Panel B: BS value to MV of equity Panel C: Adjusted BS value to MV of equity

[I] [II] [III] [IV]

State ownership [1/0] �0.004 �0.004 �0.003n�0.003n

(�1.56) (�1.53) (�1.79) (�1.8)

Firm size �0.001 �0.001 0.0004 0.0005

(�0.96) (�0.91) (1.34) (1.49)

Tobin’s Q �0.001 �0.001 �0.0004n�0.0005nnn

(�1.51) (�1.63) (�1.8) (�2.73)

Investment-to-capital 0.017n 0.014 0.007 0.004

(1.67) (1.52) (1.64) (0.98)

Long-term debt-to-assets 0.014n 0.016nn 0.001nn 0.012nnn

(1.82) (2.13) (2.07) (2.61)

Cash flow-to-assets �0.003 �0.005 0.021nnn 0.018nn

(�0.21) (�0.39) (2.95) (2.43)

Capital-to-sales �0.002nnn�0.003nnn

�0.001nn�0.001nnn

(�5.11) (�4.81) (�2.38) (�3.41)

Firm focus [1/0] �0.003 �0.001

(�1.27) (�0.82)

Mature industry [1/0] �0.003 �0.002

(�1.60) (�1.56)

Growth industry [1/0] 0.001 0.003

(0.36) (1.6)

Prior plan in effect [1/0] �0.002 �0.002 �0.000 0.0000

(�1.27) (�1.23) (�0.01) (�0.03)

Broad-based plan [1/0] 0.014nnn 0.013nnn 0.007nnn 0.006nnn

(5.27) (4.57) (5.09) (4.56)

Dividend-protected plan [1/0] 0.005nn 0.005nn 0.002 0.002n

(2.12) (2.26) (1.46) (1.81)

PV/indexed plan [1/0] �0.001 �0.001 0.002 0.002

(�0.55) (�0.55) (0.75) (0.81)

Year dummies Yes Yes Yes Yes

Adjusted R-squared 0.462 0.468 0.458 0.514

Number of observations 141 141 141 141


with a positive sign. This contradicts the hypothesis thatCash flow-to-assets proxies profitability, and higher profit-ability would be associated with less need for strongincentives if the expected marginal benefits of equity-based compensation are decreasing in firm performance.If Cash flow-to-assets instead proxies for agency costs,greater pay-performance sensitivity might be motivatedin high cash flow firms to reduce agency costs.

In summary, as determinants for the scope of theoption plan, we get the strongest results for two variablesderived from the optimal contracting theory: the Capital-

to-sales ratio as a proxy for monitoring complexity (sig-nificantly negative in all specifications), which suggeststhat options are used more in more complex firms, andTobin’s Q (systematically negative, and significant in thestock overhang specifications), which may, in line with,e.g., Morck, Shleifer, and Vishny (1988), be interpreted asa proxy for firm performance, suggesting a greater need toincentivize managers in poorly performing firms wherethe expected marginal benefits may be larger.

5.2. Factors driving the exercise price of stock options

Table 5 reports regression results for determinants ofthe stock option premium (the out-of-the-moneyness). In


Panel A of Table 5, the dependent variable is the First

tranche premium, whereas in Panel B, we use the Weighted

average premium. The table reports four different specifi-cations in each panel: either including a measure of Total

risk (specifications [I] and [II]), or with firm risk decom-posed into Systematic risk and Unsystematic risk (specifica-tions [III] and [IV]). Furthermore, the specifications eitherutilize an indicator variable for Firm focus (specifications[I] and [III]) or decompose this measure into two separatevariables for Mature industries and Growth industries

(specifications [II] and [IV]). Data for Prior stock return

are missing in four observations. We apply the samemethod that is used by Himmelberg, Hubbard, and Palia(1999) and Jin (2002), among others; that is, we setmissing observations of prior stock returns to zero andinclude a separate indicator variable that takes the valueof one for missing observations and zero otherwise.

The results in Table 5 reveal a similar picture as inTable 4; that is: that ownership structure does not seemto be related to the design of stock option plans. Further,as in the case of scope, very few potential other determi-nants obtain significance. One exception is Prior stock

return, which is inversely related to the stock optionpremium and significant at the 5% or 10% level through-out the specifications. This result supports both the




optimal contracting theory (high-water mark contracting)and the managerial power hypothesis, because both ofthese theories predict a negative sign. In terms of eco-nomic significance, the results in Panel B suggest that aunit increase in the prior (six-month) stock return

Table 5Determinants of the stock option premium.

The stock option premium (out-of-the-moneyness) is defined as [(X�S)/S], w

stock price at the grant date. In Panel A, the first tranche premium is calculated

tranche. In Panel B, the weighted average stock option premium is used. The w

shares obtainable upon exercise in each individual stock option tranche divid

options. The independent variables are measured at the end of the previous

reported). All risk measures are multiplied by 100. Data for prior stock returns

Estimation is conducted utilizing OLS. The t-statistics (reported beneath each re

5%, and 10% significance levels are denoted with nnn, nn, and n, respectively. Fina

of the Helsinki Stock Exchange (HEX) during the years 1987–2001 (see Table 1

Independent variables

Panel A: First tranche premium

[I] [II] [III]

CEO ownership 0.008 �0.006 0.028

(0.03) (�0.02) (0.10)

Non-state ownership control �0.052 �0.051 �0.054

(�0.47) (�0.46) (�0.49)

Institutional ownership [1/0] 0.018 0.011 0.014

(0.38) (0.24) (0.29)

State ownership [1/0] �0.018 �0.020 �0.018

(�0.35) (�0.38) (�0.36)

Firm size �0.002 �0.002 0.001

(�0.20) (�0.23) (0.09)

Tobin’s Q �0.005 �0.005 �0.004

(�0.80) (�0.69) (�0.54)

Investment-to-capital 0.114 0.134 0.120

(1.01) (1.13) (1.02)

Long-term debt-to-assets 0.016 0.0003 0.009

(0.11) (0.01) (0.06)

Cash flow-to-assets �0.374 �0.350 �0.344

(�1.48) (�1.38) (�1.32)

Prior stock return �0.144nn�0.135n

�0.154nn

(�2.06) (�1.80) (�2.11)

Prior stock return missing [1/0] �0.104 �0.101 �0.101

(�1.57) (�1.39) (�1.58)

Capital-to-sales 0.015 0.018 0.015

(1.37) (1.52) (1.42)

Firm focus [1/0] 0.009 0.009

(0.27) (0.26)

Mature industry [1/0] 0.015

(0.42)

Growth industry [1/0] �0.024

(�0.46)

Total risk 0.481 0.508

(1.28) (1.38)

Systematic risk 0.021

(0.02)

Unsystematic risk 0.649

(1.23)

Prior plan in effect [1/0] 0.004 0.005 0.002

(0.13) (0.14) (0.07)

Broad-based plan [1/0] 0.027 0.035 0.027

(0.61) (0.77) (0.59)

Dividend-protected plan [1/0] 0.051 0.050 0.046

(1.28) (1.27) (1.21)

PV/indexed plan [1/0] �0.073 �0.073 �0.073

(�1.52) (�1.54) (�1.53)

Year dummies Yes Yes Yes

Adjusted R-squared 0.218 0.216 0.213

Number of observations 141 141 141


translates into a stock option premium that is approxi-mately 0.2 percentage points lower.

We perform additional tests to distinguish between thetwo alternative explanations by estimating the models inTable 5 only for the observations with a positive prior

here X corresponds to the exercise price of the option and where S is the

as the out-of-the-moneyness of the stock options belonging to the first

eights used in the calculation correspond to the ratio of the number of

ed by the total number of shares obtainable upon exercise of all stock

year. A full set of year dummies is included in all specifications (not

are missing in four observations. See Appendix A for variable definitions.

gression coefficient) are calculated using robust standard errors. The 1%,

l sample: Stock option plans introduced by firms trading on the main list

).

Dependent variable

Panel B: Weighted average premium

[IV] [I] [II] [III] [IV]

0.015 �0.007 �0.011 �0.010 �0.014

(0.05) (�0.03) (�0.04) (�0.04) (�0.05)

�0.053 �0.046 �0.046 �0.046 �0.045

(�0.48) (�0.41) (�0.40) (�0.40) (�0.40)

0.007 0.030 0.028 0.030 0.028

(0.15) (0.64) (0.57) (0.66) (0.59)

�0.020 �0.028 �0.029 �0.028 �0.029

(�0.39) (�0.52) (�0.53) (�0.52) (�0.53)

0.001 0.004 0.004 0.004 0.004

(0.07) (0.35) (0.34) (0.26) (0.25)

�0.004 �0.005 �0.005 �0.005 �0.005

(�0.44) (�0.77) (�0.71) (�0.70) (�0.63)

0.140 0.063 0.070 0.062 0.069

(1.13) (0.63) (0.65) (0.59) (0.61)

�0.007 0.010 0.005 0.011 0.006

(�0.05) (0.07) (0.03) (0.08) (0.04)

�0.319 �0.363n�0.355n

�0.367n�0.359

(�1.21) (�1.76) (�1.71) (�1.73) (�1.65)

�0.146n�0.182nn

�0.179nn�0.181nn

�0.178nn

(�1.90) (�2.26) (�2.08) (�2.24) (�2.09)

�0.098 �0.070 �0.069 �0.070 �0.069

(�1.40) (�0.97) (�0.91) (�0.96) (�0.90)

0.018 0.018n 0.019 0.018n 0.019

(1.57) (1.71) (1.66) (1.69) (1.64)

0.020 0.020

(0.54) (0.53)

0.015 0.022 0.022

(0.41) (0.58) (0.58)

�0.025 0.009 0.009

(�0.46) (0.15) (0.15)

0.599n 0.608n

(1.68) (1.73)

0.044 0.661 0.668

(0.04) (0.55) (0.57)

0.678 0.576 0.586

(1.30) (1.10) (1.11)

0.003 0.001 0.001 0.001 0.001

(0.08) (0.02) (0.02) (0.02) (0.03)

0.034 0.037 0.039 0.037 0.039

(0.75) (0.79) (0.86) (0.79) (0.86)

0.045 0.074nn 0.074nn 0.075nn 0.075nn

(1.21) (2.12) (2.12) (2.28) (2.27)

�0.074 �0.082 �0.082 �0.082 �0.082

(�1.54) (�1.55) (�1.55) (�1.54) (�1.54)

Yes Yes Yes Yes Yes

0.211 0.262 0.256 0.255 0.249

141 141 141 141 141




return. If high-water mark contracting is the reason for therelation reported above between option premium and theprior stock return, such a relation should not be present inthe subsample of firms with a positive stock-price history.Using two alternative definitions for a positive prior return(one year vs. six months and 90 vs. 81 observations withpositive returns), we still obtain negative signs for Prior stock

return in the different specifications of Table 5, but thevariable is no longer significant (t-values around 1.0).17 Insummary, our test does not rule out the possibility that theobserved relation is a result of high-water mark contracting.

The coefficients for the Cash flow-to-assets ratio aresystematically negative and statistically significant inPanel B (at the 10% level in specifications [I] through[III]). Although it is not very robust, this result suggeststhat firms with higher performance set lower exerciseprices for stock options, which provides additional sup-port for the managerial power hypothesis.

Furthermore, the coefficients for Total risk are positiveand significant at the 10% level in specifications [I] and [II]of Panel B. This observation is in line with the positivesign under one of the two optimal contracting alternatives(high-water mark contracting), and in contrast to theother, that is, the view that because firm risk proxies formonitoring difficulty, riskier firms would introduce stockoptions with lower premiums. Finally, the coefficients forDividend-protected plan are positive and significantthroughout the specifications in Panel B. These resultsare consistent with the expectations in that, all otherthings being equal, dividend protection increases theexpected value of the stock option and thus reduces thenegative effect of the higher premium.

In summary, we find the Prior stock return to be thestrongest determinant of the stock option premium, andwe also get some support for a performance variable, Cash

flow-to-assets. While the first result may be in line withoptimal contracting (high-water mark contracts), a viewalso supported by the positive sign of Total risk, the latterresult also lends some support to the managerial powerhypothesis.

5.3. Additional tests regarding scope and exercise prices

Estimation results from a simultaneous equation ana-lysis are reported in Table 6. Stock option overhang andWeighted average premium are treated as endogenousvariables.18 Supporting our expectations, the results

17 If option premium is regressed on Prior stock return without other

control variables, the coefficients are significantly negative in all sub-

samples and return definitions. When only the two firm variables

exhibiting the highest t-values, together with option plan characteris-

tics, are included, Prior stock return is also negative and significant in all

but one case.18 The explanatory variables correspond to the same variables as in

Eq. (1) and (2), with the exception that an indicator variable for broad-

based plans is excluded from the premium specification. This is done to

facilitate identification in the simultaneous equation system. This choice

was made on the basis of the previous results indicating systematic

differences in the scope of stock option plans depending on the target

group of plans. However, the results in Table 6 were also found to be

robust to different choices of explanatory variables.


suggest that the Stock option premium is positively relatedto the scope, and vice versa. However, the results are notstatistically significant at conventional levels.

More importantly, the results regarding the scope ofstock option plans in Table 4 are supported by the resultsin Table 6. Specifically, the results suggest that the scopeis decreasing in Tobin’s Q and Capital-to-sales and isincreasing in Total risk. Additionally, the results revealthat the scope is greater in plans that are targeted to abroader base of employees19 and that the scope tends tobe larger in plans that involve dividend protection.

In the case of the stock option premium, the results aresimilar to the corresponding regression results in Table 5.However, the coefficients for Cash flow-to-assets and Capital-

to-sales gain higher statistical significance in the simulta-neous equation analysis. Most importantly, the documentednegative impact of Prior stock return on option premium iscorroborated by the results in Table 6, where the coefficientis negative and significant at the 1% level. The coefficient forDividend-protected plan in the premium specification ispositive; however, in this case, it is not statistically sig-nificant at conventional levels.

To further elaborate on the factors that drive exerciseprices, we estimate discrete (Probit) decision models thatpredict the launch of premium (out-of-the-money) stockoption plans. The results of these analyses are reported inTables 7 and 8. The dependent variables are constructed onthe basis of the (continuous) dependent variables in Table 5,that is, the First tranche premium and the Weighted average

premium. In Table 7, the dependent variable takes the valueof one if the plan is launched out-of-the-money and zerootherwise. The dependent variable in Table 8 is constructedwith an additional restriction such that it takes the value ofone if the stock option plan is both granted out-of-the-money and targeted at the top management of the firm andzero otherwise. Panel A of Tables 7 and 8 reports the resultsfrom the regression where the dependent variable is basedon the First tranche premium, whereas Panel B of Tables 7and 8 reports corresponding results, where the dependentvariable is based on the Weighted average premium.20

Inspection of the results regarding ownership structurein Panels A and B of Table 7 supports the same conclusion asin the previous analyses: ownership structure does notseem to be related to the design of stock option plans.

In line with our expectations for the premium, thecoefficients for the Investment-to-capital ratio are negativeand statistically significant throughout the specifications.

19 We also estimated a model for the determinants of the likelihood

of launching broad-based option plans (using a Probit model). The

results (not reported here but available from the authors) suggest that

institutional ownership significantly increases the likelihood of granting

broad-based stock option plans. We also find that the likelihood of

broad-based plans is significantly greater among firms with high growth

opportunities, a higher degree of human capital, and more cash flow

constraints (a lower free cash flow).20 The regressions in Table 7 are estimated for a marginally reduced

sample (137 observations), as the dependent variable in four observa-

tions lacking data on prior stock return is equal to unity. The regressions

in Table 8 are estimated for the full sample (141 observations) utilizing

the procedure of Himmelberg, Hubbard, and Palia (1999) and Jin (2002),

among others, for dealing with missing data.



Table 6Simultaneous equation analysis of scope and premium of stock option plans.

The table reports estimation results using the three-stage least squares (3SLS) method. The scope of the stock

option plans (stock option overhang) is measured as the fraction of equity obtained upon exercise of all granted

stock options, i.e., as the ratio of the number of shares exercisable to the sum of shares exercisable and the

number of outstanding shares at the date of the grant. Weighted average stock option premium (out-of-the-

moneyness) is defined as [(X�S)/S], where X corresponds to the exercise price of the option and where S is the

stock price at the grant date. The weights used in the calculation correspond to the ratio of the number of shares

obtainable upon exercise in each individual stock option tranche divided by the total number of shares obtainable

upon exercise of all stock options. The independent variables are measured at the end of the previous year. A full

set of year dummies is included in all specifications (not reported). All risk measures are multiplied by 100. Data

for prior stock returns are missing in four observations. We apply the method utilized by Himmelberg, Hubbard,

and Palia (1999) and Jin (2002), among others; i.e., we set missing observations of prior stock returns to zero and

include a separate indicator variable that takes the value of one for missing observations and zero otherwise.

The t-statistics (reported beneath each regression coefficient) are calculated using robust standard errors.

See Appendix A for variable definitions. The 1%, 5%, and 10% significance levels are denoted with nnn, nn, and n,

respectively. Final sample: Stock option plans introduced by firms trading on the main list of the Helsinki Stock

Exchange (HEX) during the years 1987–2001 (see Table 1).


Stock option

overhang

Weighted average

premium

Weighted average premium 0.001

(0.03)

Stock option overhang 1.488

(1.01)

CEO ownership 0.025 �0.040

(0.97) (�0.16)

Non-state ownership control 0.003 �0.051

(0.30) (�0.57)

Institutional ownership [1/0] 0.002 0.027

(0.49) (0.59)

State ownership [1/0] �0.007 �0.019

(�1.29) (�0.39)

Firm size �0.002n 0.008

(�1.72) (0.65)

Tobin’s Q �0.003nnn�0.001

(�4.90) (�0.24)

Investment-to-capital 0.017n 0.038

(1.92) (0.43)

Long-term debt-to-assets 0.016 �0.011

(1.45) (�0.10)

Cash flow-to-assets 0.030 �0.396nn

(1.22) (�2.02)

Prior stock return �0.186nnn

(�3.30)

Prior stock return missing [1/0] �0.053

(�0.64)

Capital-to-sales �0.003nn 0.022nnn

(�2.50) (2.84)

Firm focus [1/0] �0.003 0.024

(�0.70) (0.70)

Total risk 0.081nn 0.472n

(2.51) (1.66)

Prior plan in effect [1/0] �0.002 0.003

(�0.48) (0.09)

Broad-based plan [1/0] 0.025nnn

(6.46)

Dividend-protected plan [1/0] 0.011nn 0.057

(2.30) (1.43)

PV/indexed plan [1/0] �0.0003 �0.081

(�0.06) (�1.56)

Year dummies Yes Yes

Adjusted R-squared 0.482 0.215

Number of observations 141 141


Choe (2003) shows, all other things being equal, that theoptimal exercise price of stock options is decreasing in theriskiness of the firm’s desired investment policy. Theresult appears consistent with this view if one assumes


that investment intensity is a proxy for the riskiness ofthe firm’s investment policy. Furthermore, in support ofour expectations and prior findings for the premium(in Table 5), the results in Table 7 indicate that the



Table 7Probit estimation results predicting the launch of premium stock option plans.

The stock option premium (out-of-the-moneyness, OTM) is defined as [(X�S)/S], where X corresponds to the exercise price of the option and where S is

the stock price at the grant date. In Panel A, the dependent variable takes the value of one if the first tranche premium is positive and zero otherwise. In

Panel B, the dependent variable takes the value of one if the weighted average premium is positive and zero otherwise. The independent variables are

measured at the end of the previous year. All risk measures are multiplied by 100. Final sample: Stock option plans introduced by firms trading on the

main list of the Helsinki Stock Exchange (HEX) during the years 1987–2001 (see Table 1). The dependent variable in four observations lacking data on

prior stock return is set equal to unity. The regressions are therefore estimated for the reduced sample (137 observations) including complete data on

prior stock returns. See Appendix A for variable definitions. The t-statistics (reported beneath each regression coefficient) are calculated using robust

standard errors. The 1%, 5%, and 10% significance levels are denoted with nnn, nn, and n, respectively.


Panel A: First tranche premium OTM [1/0] Panel B: Weighted average premium OTM [1/0]

[I] [II] [III] [IV] [I] [II] [III] [IV]

CEO ownership �0.924 �0.997 �1.432 �1.501 �1.123 �1.210 �1.753 �1.841

(�0.43) (�0.46) (�0.65) (�0.68) (�0.51) (�0.55) (�0.80) (�0.84)

Non-state ownership control �0.942 �0.952 �0.840 �0.854 �1.100 �1.115 �0.993 �1.012

(�1.09) (�1.11) (�0.95) (�0.97) (�1.26) (�1.29) (�1.10) (�1.13)

Institutional ownership [1/0] �0.090 �0.131 0.010 �0.032 �0.054 �0.101 0.072 0.022

(�0.21) (�0.31) (0.02) (�0.07) (�0.13) (�0.24) (0.17) (0.05)

State ownership [1/0] �0.170 �0.183 �0.190 �0.203 �0.271 �0.287 �0.297 �0.315

(�0.40) (�0.43) (�0.44) (�0.47) (�0.63) (�0.67) (�0.67) (�0.72)

Firm size �0.032 �0.032 �0.114 �0.114 �0.046 �0.047 �0.145 �0.146

(�0.30) (�0.31) (�0.97) (�0.97) (�0.44) (�0.44) (�1.22) (�1.22)

Tobin’s Q 0.027 0.029 �0.008 �0.007 0.030 0.032 �0.011 �0.009

(0.55) (0.59) (�0.16) (�0.12) (0.60) (0.65) (�0.20) (�0.17)

Investment-to-capital �1.539nn�1.364n

�1.627nn�1.457nn

�1.673nn�1.474n

�1.785nnn�1.588nn

(�2.27) (�1.84) (�2.45) (�2.00) (�2.42) (�1.95) (�2.66) (�2.15)

Long-term debt-to-assets �0.390 �0.521 �0.342 �0.462 �0.193 �0.346 �0.121 �0.262

(�0.40) (�0.53) (�0.35) (�0.47) (�0.19) (�0.34) (�0.12) (�0.26)

Cash flow-to-assets �3.553n�3.435n

�4.479nn�4.363nn

�3.993nn�3.861nn

�5.137nnn�5.010nnn

(�1.87) (�1.80) (�2.41) (�2.33) (�2.08) (�2.01) (�2.79) (�2.71)

Prior stock return �0.538 �0.481 �0.328 �0.273 �0.426 �0.358 �0.169 �0.100

(�1.12) (�1.00) (�0.65) (�0.54) (�0.87) (�0.74) (�0.33) (�0.20)

Capital-to-sales 0.146nn 0.161nn 0.163nn 0.175nn 0.147nn 0.164nnn 0.169nn 0.182nn

(2.58) (2.55) (2.39) (2.48) (2.59) (2.62) (2.33) (2.48)

Firm focus [1/0] �0.031 0.0002 0.045 0.085

(�0.09) (0.01) (0.14) (0.25)

Mature industry [1/0] 0.007 0.037 0.090 0.130

(0.02) (0.11) (0.27) (0.38)

Growth industry [1/0] �0.237 �0.202 �0.194 �0.154

(�0.48) (�0.40) (�0.39) (�0.31)

Total risk �0.494 �0.228 �0.088 0.230

(�0.22) (�0.10) (�0.04) (0.10)

Systematic risk 10.967 11.198 13.469 13.812

(1.21) (1.23) (1.47) (1.50)

Unsystematic risk �3.952 �3.675 �4.189 �3.864

(�1.16) (�1.07) (�1.20) (�1.10)

Prior plan in effect [1/0] �0.221 �0.213 �0.125 �0.119 �0.263 �0.255 �0.153 �0.145

(�0.76) (�0.74) (�0.43) (�0.41) (�0.90) (�0.87) (�0.52) (�0.49)

Broad-based plan [1/0] 0.063 0.119 0.098 0.155 0.014 0.082 0.057 0.127

(0.18) (0.33) (0.28) (0.42) (0.04) (0.22) (0.16) (0.35)

Dividend-protected plan [1/0] 0.367 0.353 0.419 0.407 0.355 0.339 0.420 0.406

(1.23) (1.18) (1.39) (1.35) (1.17) (1.11) (1.38) (1.33)

PV/indexed plan [1/0] �0.535 �0.531 �0.511 �0.508 �0.509 �0.504 �0.485 �0.482

(�1.13) (�1.13) (�1.04) (�1.05) (�1.08) (�1.08) (�0.98) (�0.99)

Log likelihood �75.518 �75.356 �74.645 �74.494 �73.999 �73.782 �72.803 �72.594

Pseudo R-squared 0.122 0.124 0.132 0.134 0.132 0.134 0.146 0.148

Dependent variable [at 1 in %] 0.679 0.679 0.679 0.679 0.686 0.686 0.686 0.686

Number of observations 137 137 137 137 137 137 137 137


likelihood of granting premium (out-of-the-money) stockoptions is decreasing in firm profitability (measured asthe ratio of Cash flow-to-assets) because the coefficients ofthe Cash flow-to-assets ratio are negative and statisticallysignificant in all specifications.

Finally, the coefficients of Capital-to-sales are againpositive (as expected and obtained for the premium in


Table 5) and now statistically significant in all specificationsreported in Table 7. We have interpreted Capital-to-sales as aproxy for monitoring complexity. Lower monitoring costs(a higher Capital-to-sales) seem to be associated with ahigher likelihood of granting premium (out-of-the-money)stock options, which is in line with our expectations becauseon a share-for-share basis, the pay-for-performance



Table 8Probit estimation results predicting the launch of premium stock option plans targeted to top management.

The stock option premium (out-of-the-moneyness) is defined as [(X�S)/S], where X corresponds to the exercise price of the option and where S is the

stock price at the grant date. In Panel A, the dependent variable takes the value of one if the first tranche premium is positive and the plan is targeted

solely to top management and zero otherwise. In Panel B, the dependent variable takes the value of one if the weighted average premium is positive and

the plan is targeted solely to top management and zero otherwise. The independent variables are measured at the end of the previous year. All risk

measures are multiplied by 100. Data for prior stock return are missing in four observations. See Appendix A for variable definitions. The t-statistics

(reported beneath each regression coefficient) are calculated using robust standard errors. The 1%, 5%, and 10% significance levels are denoted with nnn, nn,

and n, respectively. Final sample: Stock option plans introduced by firms trading on the main list of the Helsinki Stock Exchange (HEX) during the years

1987–2001 (see Table 1).


Panel A: First tranche premium OTM in planstargeted to top management [1/0]

Panel B: Weighted average premium OTMin plans targeted to top management [1/0]

[I] [II] [III] [IV] [I] [II] [III] [IV]

CEO ownership �2.090 �2.088 �2.069 �2.068 �2.300 �2.305 �2.318 �2.322

(�1.02) (�1.01) (�1.00) (�0.99) (�1.13) (�1.12) (�1.13) (�1.12)

Non-state ownership control �1.311n�1.312 �1.319n

�1.319 �1.478n�1.474n

�1.472n�1.468n

(�1.66) (�1.63) (�1.66) (�1.63) (�1.85) (�1.82) (�1.83) (�1.80)

Institutional ownership [1/0] �0.348 �0.348 �0.352 �0.352 �0.309 �0.311 �0.306 �0.307

(�0.88) (�0.88) (�0.89) (�0.89) (�0.78) (�0.78) (�0.77) (�0.77)

State ownership [1/0] �0.265 �0.265 �0.265 �0.265 �0.369 �0.369 �0.370 �0.369

(�0.63) (�0.63) (�0.63) (�0.63) (�0.87) (�0.87) (�0.87) (�0.87)

Firm size 0.082 0.082 0.086 0.086 0.074 0.074 0.071 0.071

(0.83) (0.82) (0.77) (0.76) (0.74) (0.73) (0.63) (0.63)

Tobin’s Q �0.079 �0.080 �0.078 �0.078 �0.085 �0.084 �0.087 �0.086

(�1.19) (�1.06) (�1.13) (�1.00) (�1.29) (�1.14) (�1.26) (�1.10)

Investment-to-capital �1.415nn�1.418n

�1.406nn�1.407n

�1.541nn�1.530nn

�1.549nn�1.539nn

(�2.17) (�1.90) (�2.12) (�1.85) (�2.32) (�2.02) (�2.29) (�1.99)

Long-term debt-to-assets 0.137 0.138 0.132 0.133 0.310 0.304 0.314 0.309

(0.15) (0.15) (0.15) (0.15) (0.34) (0.33) (0.35) (0.34)

Cash flow-to-assets �3.494n�3.495n

�3.460n�3.460n

�3.925nn�3.919nn

�3.955nn�3.949nn

(�1.89) (�1.87) (�1.84) (�1.82) (�2.09) (�2.07) (�2.08) (�2.05)

Prior stock return �0.216 �0.216 �0.224 �0.224 �0.075 �0.073 �0.068 �0.067

(�0.46) (�0.46) (�0.48) (�0.47) (�0.16) (�0.16) (�0.15) (�0.14)

Prior stock return missing [1/0] �0.396 �0.397 �0.392 �0.392 �0.411 �0.409 �0.416 �0.414

(�0.47) (�0.47) (�0.46) (�0.46) (�0.48) (�0.48) (�0.48) (�0.48)

Capital-to-sales �0.143nn�0.144nn

�0.143nn�0.143nn

�0.145nn�0.144nn

�0.146nn�0.145nn

(�2.34) (�2.02) (�2.32) (�2.00) (�2.39) (�2.04) (�2.38) (�2.02)

Firm focus [1/0] �0.126 �0.128 �0.058 �0.057

(�0.40) (�0.41) (�0.19) (�0.18)

Mature industry [1/0] �0.127 �0.128 �0.056 �0.055

(�0.40) (�0.40) (�0.18) (�0.17)

Growth industry [1/0] �0.124 �0.127 �0.071 �0.068

(�0.25) (�0.25) (�0.14) (�0.13)

Total risk �1.422 �1.423 �1.138 �1.132

(�0.66) (�0.66) (�0.53) (�0.52)

Systematic risk �2.012 �2.011 �0.632 �0.646

(�0.26) (�0.26) (�0.08) (�0.08)

Unsystematic risk �1.236 �1.237 �1.298 �1.286

(�0.36) (�0.36) (�0.38) (�0.37)

Prior plan in effect [1/0] 0.244 0.244 0.240 0.240 0.219 0.218 0.222 0.221

(0.91) (0.91) (0.89) (0.89) (0.81) (0.80) (0.81) (0.81)

Dividend�protected plan [1/0] 0.027 0.027 0.025 0.025 0.021 0.021 0.023 0.023

(0.10) (0.10) (0.09) (0.09) (0.07) (0.07) (0.08) (0.08)

PV/indexed plan [1/0] �0.164 �0.164 �0.165 �0.165 �0.132 �0.132 �0.131 �0.131

(�0.34) (�0.34) (�0.34) (�0.34) (�0.27) (�0.28) (�0.27) (�0.27)

Log likelihood �80.938 �80.938 �80.935 �80.935 �80.044 �80.044 �80.042 �80.042

Pseudo R-squared 0.171 0.171 0.171 0.171 0.180 0.180 0.180 0.180

Dependent variable [at 1 in %] 0.518 0.518 0.518 0.518 0.525 0.525 0.525 0.525

Number of observations 141 141 141 141 141 141 141 141


sensitivity of out-of-the-money stock options is lower thanthat of corresponding in-the-money or at-the-money stockoptions (see, e.g., Lambert, Larcker, and Verrecchia, 1991).

Regression results that predict the launch of premiumstock options targeted at top management are reported inTable 8. The dependent variable in Table 8 takes the value


of one if the stock option plan is launched out-of-the-money and is targeted at the top management, and zerootherwise. The results in Table 8 are generally similar tothe results reported in Table 7. First, the coefficients of theInvestment-to-capital are negative and statistically signifi-cant throughout the specifications in Table 8 and thus



21 See, e.g., Tainio and Lilja (2003) and Yla-Anttila, Ali-Yrkko, and

Nyberg (2004). There have also been several institutional changes during

our time period, supporting such a perception. These include the

increased foreign ownership (much of which is US-based) since 1993,

when restrictions for foreign ownership were abolished, new corporate

governance codes with features from the US or U.K., Finland’s entry to

the European Union 1995, and many financial market reforms increased

the competition and market orientation of Finnish firms.


support the results reported in Table 7. The previouslydocumented negative relation between the likelihood ofgranting premium stock options and firm profitability isfurther strengthened by the results in Table 8, where allcoefficients of Cash flow-to-assets are negative and statis-tically significant in the reported specifications. Finally,in contrast to the results presented in Table 7, the resultsin Table 8 suggest that a higher Capital-to-sales (lowermonitoring costs) reduces the likelihood of granting pre-mium stock options to top management.

Finally, we test for a relation between the premiumand the vesting period. Bebchuk, Fried, and Walker (2002)claim that in the US, at-the-money options are issuedirrespective of the vesting period. If stock prices areexpected to increase on average, then less managerialeffort would be required to make longer vesting-periodoptions end up in-the-money (such options would thusconstitute ‘‘a royalty on the passage of time,’’ and thegranting of such options would be an indication ofmanagerial power). Table 9, Panel A, reports descriptivestatistics for option programs with different numbers oftranches. Tranches within a program are all granted at thesame date, but higher order tranches in our dataset always have a longer vesting period and often have adifferent strike price (and usually have the same time-to-maturity). As Panel A shows, option premiums are gen-erally higher for tranches with longer vesting periods (thedifferences are not significant, however).

Higher option premiums for higher tranches might berelated not only to the increased vesting period, but alsoto the higher time-to-maturity. Even if options withlonger maturities have higher exercise prices, they stillmight be both more valuable at the grant date andassociated with a higher delta. That is, a higher strikeprice does not guarantee that less value is distributedthrough options with a longer maturity and vesting period.We therefore construct a stronger test for the vesting-periodeffect. Panel B of Table 9 reports results for pair-wisecomparisons of different tranches within the same optionprograms. Only pairs with identical maturity but differentvesting periods (options from different tranches but for thesame firm and same program) are selected for comparison.In fixing maturity, we indirectly control for value becausegiven identical exercise prices, options with a shortervesting period should be at least as valuable as other options(they can be exercised at the same time as others or earlier).If exercise prices increase with the length of the vestingperiod, then the results speak against the idea that optionswith longer vesting periods would be more generous.

Panel B shows that all pair-wise average differencesare positive, that is, option premiums increase withvesting periods even when maturity is kept constant.When the sample size is larger (tranche 1 vs. tranche 2,77 observations), the average difference in premiums issignificant at the 1% level (a t-value of 2.48). The sameholds for the difference between the premiums for allpairs with identical maturities (180 observations and at-value of 2.71). These results contradict the managerialpower hypothesis, and support the optimal contractingview in the sense that when no institutional factors drivegranting at-the-money options, the shareholders will


grant more out-of-the-money options when their vestingperiods are further in the future to avoid rewardingsimply for ‘‘the passing of time.’’

5.4. Additional tests related to comparability to

other markets

The results presented in this paper are based on datafor a small Nordic market (Finland). An important ques-tion is whether these results also convey informationabout the design of executive option programs in othermarkets where additional tax and accounting rule-baseddistortions do not apply.

When we compare Finland with the US and Continen-tal Europe (see Section 4.1), we note that in terms ofownership concentration, Finland lies in between the USand Continental Europe but that there is much morecross-sectional variation in ownership concentration inFinland as compared with typical Continental Europeancountries.

To test for potential differences in the setting of theexercise price that stem from different ownership struc-tures, we split the sample into two approximately equalparts (70 versus 71 observations) with regard to Non-state

ownership control. The average premium is larger in firmswith a non-state ownership share that is below average(0.1155 vs. 0.0918), but the difference is insignificant.

Many authors argue that shareholder orientation inFinland has increased over time.21 Again, splitting thesample into two parts based on the timing of the programlaunch reveals that the premium has increased (i.e., thelatter options programs are more out-of-the-money,though not significantly so, with average premiums grow-ing from 0.0699 to 0.1134) in the more recent subperiod(1995�2001). Larger programs (i.e., programs withpotentially more powerful incentives) also have a higherpremium (0.1218 vs. 0.0851), but the difference is notsignificant. These results do not support the perceptionthat moving towards more shareholder orientation andmore powerful incentive compensation would lead todecreased premiums and to programs with more at-the-money options as in the US.

Benchmarking with respect to a peer group is found tobe widespread in recent empirical studies of compensa-tion: see, e.g., Bizjak, Lemmon, and Naveen (2008) andFaulkender and Yang (2010). The latter find that firmsappear to select highly paid peers to justify their CEOcompensation. It is possible that executive option prac-tices in Finland would also be influenced by some impor-tant peer group(s), especially because the number oflisted firms is small and a dominating advisory firm(Alexander Corporate Finance) is involved in tailoring



Table 9Analysis of option premiums vs. vesting periods.

Panel A reports (for each tranche) the average premium, standard deviation, time-to-maturity, and vesting period for options from programs with

different numbers of tranches. In Panel B, the analysis is restricted to different matched pairs (within a program) with identical time-to-maturity but

with different vesting periods, and potentially different premiums, since coming from different tranches. We report the statistics for the average

difference in premiums (higher tranche premium minus lower tranche premium) and vesting periods for such pairs. The t-test tests for whether such

average differences in premiums are different from zero. Significant t-values at the 1% level (one-sided tests) are denoted in boldface. Final sample 141

observations (see Table 1).

Panel A: Number of tranches in program

1st Tranche 2nd Tranche 3rd Tranche 4th Tranche 5th Tranche

1 Average premium 0.0804

(N¼50) Stdev premium 0.1747

Average time-to-maturity 6.2003

Average vesting period 3.0923

2 Average premium 0.1181 0.1325

(N¼49) Stdev premium 0.1443 0.1414

Average time-to-maturity 5.9479 6.2542

Average vesting period 2.4310 4.0886

3 Average premium 0.1007 0.1346 0.1449

(N¼28) Stdev premium 0.2132 0.2325 0.2805

Average time-to-maturity 5.8062 6.0919 6.2866

Average vesting period 2.2297 3.3614 4.3534

4 Average premium 0.1796 0.1978 0.1980 0.2162

(N¼11) Stdev premium 0.1705 0.1971 0.2404 0.2721

Average time-to-maturity 6.1333 6.1333 6.4062 6.4062

Average vesting period 1.8371 2.7925 3.7479 4.7938

5 Average premium 0.0004 0.0004 0.0004 0.0004 0.0004

(N¼3) Stdev premium 0.0006 0.0006 0.0006 0.0006 0.0006

Average time-to-maturity 6.4950 6.4950 6.8283 6.8283 6.9945

Average vesting period 1.1306 1.7973 2.7991 3.4658 4.2995

All programs Average premium 0.1036 0.1367 0.1485 0.1699 0.0004

(N¼141) Stdev premium 0.1721 0.1797 0.2611 0.2557 0.0006

Average time-to-maturity 6.0354 6.1976 6.3566 6.4967 6.9945

Average vesting period 2.5516 3.6326 4.0838 4.5092 4.2995

Panel B: Different tranches (but same program and time-to-maturity) compared

1st Tranche 2nd Tranche 3rd Tranche All pairs

2nd Tranche Average difference in premium 0.0161

St. error of mean 0.0065

t-Test, paired sample 2.48Average diff. in vesting period 1.3299

N 77

3rd Tranche Average difference in premium 0.0389 0.0222

St. error of mean 0.0276 0.0222

t-Test, paired sample 1.41 1.00

Average diff. in vesting period 1.9844 0.9152

N 34 32

4th Trance Average difference in premium 0.0269 0.0080 0.0143

St. error of mean 0.0473 0.0352 0.0091

t-Test, paired sample 0.57 0.23 1.57

Average diff. in vesting period 2.8658 1.9180 0.9646

N 11 12 14

All pairs Average difference in premium 0.0215

St. error of mean 0.0079

t-Test, paired sample 2.71Average diff. in vesting period 1.4844

N 180


most of the executive compensation programs. Differentpeer groups might create significant variation in optionpremiums across industries, for example, or firms with aforeign listing might follow different, more US-influencedstandards. We test for the effect of peer groups both by


looking at the cross-sectional variation across industriesand by partitioning the sample based on foreign owner-ship or international listing.

Although we do find some variation across industries,the average premium is always positive and is only below




10% in two industries, IT & Telecom (an average premiumof 7%), and Consumer Staples (8.3%). The standard devia-tions for the premium are wide in each industry, and thedifferences in means are not significantly different fromeach other at the 5% level.

In Finland, foreign ownership varies substantiallyacross firms, from mainly foreign-owned and US-listedfirms such as Nokia to smaller, mainly domesticallycontrolled listed firms. When dividing the sample in twobased on foreign ownership, we find that firms withforeign ownership above the median have slightly smallerpremiums (0.0952 vs. 0.1120), and the programs of firmswith a foreign listing, mostly in the US (40 observations),are even smaller (0.0754). However, these differences arefar from significant and dually listed firms also haveprograms that are, on average, 7.5% out-of-the-money.

6. Summary and conclusions

This paper examines the relations between firm char-acteristics and the design of stock option plans for Finnishfirms. Most existing empirical studies concentrate on theincentive effects provided by equity-based compensation(see, e.g., Yermack, 1995). However, the variation incontract design is rather limited for US firms, especiallyin setting exercise prices, which is caused by tax andaccounting considerations (Murphy, 1999). In contrast,Finnish firms are not subject to the tax- and accounting-induced restrictions in the design of stock option plans.This paper thus extends the literature in the followingmanner. We examine determinants of the two maindesign attributes of stock option plans: the scope of stockoption plans and the setting of exercise prices. In practice,these two variables are shareholders’ main considerationswhen evaluating and approving compensation proposals.To our knowledge, this paper is the first to provide arigorous analysis of the factors that determine the exer-cise price of stock options. We also study the relationbetween the out-of-the-moneyness of the granted optionsand the length of their vesting period when options aregranted from several tranches.

We find that the scope of the option plan is inverselyrelated to Tobin’s Q. Several prior studies employ Tobin’sQ as a measure of firm performance (see, e.g., Morck,Shleifer, and Vishny, 1988). Under that interpretation, thisresult suggests that poorly performing firms grant largerstock option plans. Furthermore, we find that the scope ofstock option plans is decreasing in the capital-to-salesratio of the firm and in firm size and is increasing in firmrisk. These results are consistent with traditional princi-pal-agent theory, which argues that greater monitoringcosts/difficulty should be positively related to the amount ofequity-based compensation (Holmstrom, 1979; Demsetzand Lehn, 1985; Milgrom and Roberts, 1992), and with theidea that management productivity increases less thanproportionally with firm size (Baker and Hall, 2004).

We find that the size of the stock option premium (itsout-of-the-moneyness) is very negatively related to the priorstock return. This result is consistent with two alternativeinterpretations, one from the optimal contracting literature,and one from the managerial power literature. Under optimal


contracting, using high-water mark features in compensationcontracts (i.e., introducing out-of-the-money options) may beoptimal especially in high volatility industries. The alternativeview would be that managers have more negotiating powerregarding the design of compensation in firms with greaterprior stock price performance, which leads to more in-the-money options. Our additional tests do not allow us tostrongly distinguish between these two alternatives. How-ever, the first view is somewhat supported by the result thattotal risk is significant and positively related to the optionpremium.

In different specifications for the option premium andfor the likelihood of launching premium options, we alsoobtain support for other variables related to firm profit-ability (such as cash flow-to-assets). These specificationsindicate that less (more) profitable firms are more likelyto grant premium (discount, i.e., in-the-money) options.Because we also find support for variables that proxy formonitoring costs, our results concerning the exerciseprice setting support both optimal contracting variablesbut may also be interpreted as lending some support tothe managerial power hypothesis.

Finally, we report a significant positive relationbetween the option premium (out-of-the-moneyness)and the length of the vesting period. In a pair-wisecomparison of different tranches from the same optionprograms (with the same maturity, but different vestingperiods), we find that the average option premium alwaysincreases with the length of the vesting period. Whencomparing all pairs, the difference between trancheaverages is significant at the 1% level. Our results provideclear support for an optimal contracting view in the sensethat when no institutional factors drive shareholderstoward granting at-the-money options, they will grantmore out-of-the-money options when the vesting periodsare further in the future to avoid reducing the managers’incentives over time.

Appendix A. Variable definitions for key variables

The table describes our key variables. Financial state-ment data are from the ETLA database, firm ownershipdata are from Porssiyhtiot books and the Finnish CentralSecurities Depository (from 1993 onwards), financialmarket data are from DataStream and the databases atthe Hanken School of Economics, and ESOP data are fromAlexander Corporate Finance Oy. We have hand collectedpress releases regarding the decisions of stock optionplans to enable the exact specification of, e.g., the stockoption premium at the date of grant. The time period is1987�2001, and the sample covers 141 stock optionplans (Table A1).

Appendix B. Summary of expected signs for keyexplanatory variables

The table summarizes the expected signs for our keyvariables in the models for the scope of the stock optionplan as well as the exercise price. The signs are mainlyderived using predictions from either the optimal con-tracting literature or the managerial power literature.



Table A1

Variable Description

Stock option overhang The number of shares exercisable to the sum of shares exercisable and the number of all already

outstanding shares at the grant date

Call option value of option plan to market

value of equity

For options without dividend protection, we use the Merton (1973) model, i.e., adjust for expected

dividends using the annual dividend yield; otherwise, we use the B&S (1973) model. The risk-free rate is

the three-month money market rate (HELIBOR, later EURIBOR) at grant date. The stock return volatility is

the annualized standard deviation of daily stock returns over 250 previous trading days (with a minimum

of 60 observations as inclusion criteria)

The total value of stock options in one tranche is their B&S value (with tranche-specific parameters)

multiplied by the number of shares obtainable upon exercise of all options in that tranche

The total value of stock options granted to the market value of equity is obtained by summing the total values of

all tranches in a stock option plan and dividing this value by the market value of firm equity at grant date

Adjusted call option value of option plan to

market value of equity

To adjust for the fact that managers may not be able to fully hedge their position in the market, we use

the method suggested by Meulbroek (2001) to value the options held by the fully undiversified manager.

The method is based on a Sharpe ratio approach where the manager is expected to require the same risk-

adjusted return for the stock as for the market, and the spot price is adjusted according to this. In

calculating the adjusted stock price, we have assumed a market return of 15%, risk-free rate of 5%, and

market volatility of 30%. The option values are then calculated as above using the adjusted value for the

current stock price

Stock option premium (tranche specific) Calculated as (X�S)/S, where S is the current stock price and X is as follows:

(1) If the exact exercise price of stock options is specified at the grant date, then this value is used as X. This

is the case in most stock option plans in the study

(2) If the exercise price is defined as the average exercise price during some specified time period in the

future, then the stock option is assumed to be granted at-the-money (X¼S)

(3) If the exercise price of the option is defined as the average exercise price during some time period in the

future plus a fixed or percentage premium, then the option is assumed to be granted with an exercise

price equal to S plus the given premium

(4) If the exercise price of the option cannot be determined with certainty at the date of grant, but a certain

minimum exercise price is specified, then the option is assumed to be granted with that minimum

exercise price. This is the case in a number of performance-vested/indexed stock options

First tranche premium [(X�S)/S], where X is the exercise price in the first tranche of the option plan, and S is the stock price grant

date

Weighted average premium (option plan

specific)

A weighted sum of the stock option premiums of all tranches in an option plan. As weights, the ratio of

the number of shares obtainable upon exercise of an individual stock option tranche, divided by the total

number of shares obtainable upon exercise of all tranches, is used

The target group of the stock option plans Stock option plans are defined as being targeted to top management if that group is the sole target of the

plan. If stock options are also targeted to non-executive employees, the stock option plan is defined as a

broad-based plan

CEO ownership The fraction of shares held by the CEO of the firm. Porssitieto only records the 20 largest shareholders of

the firm. This variable thus takes the value of zero if the CEO is not among this group of shareholders

Non-state ownership control The fraction of all shares held by the three largest non-state shareholders

Institutional ownership, State ownership Indicator variables taking the value of one if a financial institution or the state is among the three largest

shareholders, respectively, and zero otherwise

Foreign ownership The fraction of shares held by foreign investors at the end of the accounting period

Firm size The logarithm of the book value of assets

Tobin’s Q The market value of equity and the book value of total debt, divided by the book value of assets. Market

values of equity (annual) are obtained from KOP Porssiyhtiot manuals and Kauppalehti databases

Investment-to-capital Gross investment in fixed assets during the accounting period divided by fixed assets (book value of gross

plant, property, and equipment)

Long-term debt-to-assets The book value of long-term debt divided by the book value of assets

Cash flow-to-assets The ratio of EBITDA to the book value of assets

Free cash flow-to-assets The ratio of EBITDA less gross investment and total dividends to the book value of assets

Prior stock return The six-month (125 trading days) logarithmic stock return preceding the end of the accounting period

during the year before the launch of stock option plans

Capital-to-sales The ratio of fixed assets (book value of gross plant, property, and equipment) to sales

Wages per employee The ratio of total labor costs to the average number of employees

Firm focus A dummy that takes the value of one if at least 60% of the firm’s annual sales are generated from one

specific industry segment according to ETLA’s classification, and zero otherwise (diversified industry)

Mature vs. Growth Firm focus is further decomposed into mature and growth industries. See Table 2, Panel C, for which

industries are classified as mature vs. growth industries

Dividend-protected plans In dividend-protected stock option plans, exercise prices are adjusted (reduced) on the ex-dividend date

for the amount of dividend payments per share

Total risk The variance of daily stock total returns during the firm’s accounting period, using a minimum of 60 daily

stock returns as inclusion criteria

Systematic risk Estimated by a year-to-year market model regression based on daily stock returns, and calculated as the

squared beta multiplied by the variance of daily market index returns. As the market index, we have used

the Helsinki Stock Exchange (HEX) Portfolio total return index from 1991 onwards (to control for the

Nokia effect, this index has a single firm weight cap of 10%), and prior to that, the WI index calculated at

the Hanken School of Economics (for its suitability, see, e.g., Knif, 1988)

Unsystematic risk Residual variance from a year-to-year market model regression based on daily stock returns

Please cite this article as: Liljeblom, E., et al., What determines stock option contract design? Journal of FinancialEconomics (2011), doi:10.1016/j.jfineco.2011.02.021



Table B1

Variable I. Model for the scope of the stock option plan II. Model for the stock option premium

Based on optimalcontracting

Based onmanagerial power

Other Based on optimalcontracting

Based onmanagerial power

Other

CEO ownership � þ �

Non-state ownership

control

� � þ

Institutional ownership þ � þ

State ownership � þ

Firm size � ?

Tobin’s Q 7 � �

Investment-to-capital þ �

Profitability (cash flow-to-

assets)

� �

Leverage (long-term debt-

to-assets)

� �

Prior stock return � �

Capital-to-sales � þ

Firm focus � þ

Total risk 7 7Systematic risk 7 7Unsystematic risk 7 7Prior plan in effect � ?

Broad-based plan þ ?

Dividend-protected plan ? þ

PV/indexed plan ? �


‘‘7 ‘‘ denotes a case where there are theoretical argu-ments for both a positive and a negative effect, whereas‘‘?’’ denotes a case where, based on theoretical arguments,an expectation for the sign is hard to formulate for somecontrol variable that we still want to include in the model.Prior stock return is only included in model II (Table B1).

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