What Determines Stock Option Contract Design?

Abstract

We analyze factors driving exercise price policy for executive option plans (ESOPs), and their scope, in a country where firms are not subject to such tax and accounting considerations, that have seemed to led to a dominance of at-the-money options in the U.S. Our “unbounded” data for Finland provides 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 contracting 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 explain the probability for launching premium ESOPs. However, our results also show that the premium (out-of-the-moneyness) is negatively related to prior stock return and cash flow to assets, which may indicate higher managerial powers, leading to more in-the-money options, in well-performing firms. Finally, we also report a positive relationship between the premium and the length of the vesting period, indicating an effort to keep the incentives for the management from falling over time.

Keywords: Stock option contract design, Optimal contracting, Agency costs

JEL Classification: G30, G32, J33