Employee stock option plans and stock market reaction: evidence from ...

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This paper examines whether the adoption of stock option plans results in changes in shareholders' wealth, and whether the stock market reactions to ESOP ...

The European Journal of Finance 10, 105–122 (April 2004)

Employee stock option plans and stock market reaction: evidence from Finland 1 ¨ SEPPO IKAHEIMO , ANDERS KJELLMAN2 , JAN HOLMBERG3 and SARI JUSSILA4 1 Helsinki

School of Economics Akademi University 3 Åbo Akademi University 4Turku School of Economics and Business Administration, Unit of Pori 2 Åbo

This paper examines whether the adoption of stock option plans results in changes in shareholders’ wealth, and whether the stock market reactions to ESOP announcements could be explained by the target group of ESOP and the dilution effect. Short-horizon test methods are applied for this purpose. The sample consists of ESOP announcements of Finnish publicly quoted companies on the Helsinki Stock Exchange during the time period 1988–1998. The event study results show a slightly positive market reaction to announcements of ESOPs targeted to management and a negative market reaction in the case of ESOPs targeted to all employees. The results of regression analysis show that the ESOPs with limited dilution convey positive information to the stock market and the dilution effect has a negative impact on stock returns, especially in the case of ESOPs targeted to all employees. Keywords: stock options, security market reaction

1.

INTRODUCTION

Employee stock option plans (ESOP) have been proposed as wealth-increasing means to control management behaviour and to motivate managers to make better decisions through aligning the interests of management with those of shareholders. A positive relationship between managerial compensation and firm performance has been found in previous studies, e.g. Zhou (1999) and Jensen and Murphy (1990). Clark and Philippatos (1998) argue that ESOPs drive managers to undertake more profitable projects. In addition, ESOPs may motivate managers to undertake more risky projects as well as to commit themselves to the company for a longer time period. The employee stock options (ESO) will grant executives or all employees the right to purchase a number of shares at a stated price during a certain time period. The subscription of ESOs will cause a cost to the current shareholders in a similar ∗

Corresponding author. Helsinki School of Economics and Business Administration P.O. Box 1210 FIN – 00101 Helsinki Finland. Tel.: +358 9 43 138 474; Fax: +358 9 43 138 678; E-mail: [email protected]fi. The European Journal of Finance c 2004 Taylor & Francis Ltd ISSN 1351-847X print/ISSN 1466-4364 online  http://www.tandf.co.uk/journals DOI: 10.1080/1351847032000137447

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manner to equity offers, which are executed as rights issues. This cost can be seen as the price of current shareholders to create motivation for employees. Thus, the execution of ESOs creates a wealth transfer from shareholders to employees causing a dilution effect. Recent discussions in the USA and Europe have shown that the dilution effect may play an important role in the ESOPs, since ESOPs targeted at company executives have been criticised for being generous to top management.1 This means that the current owners pay too much to management compared with the increase in the level of motivation. Recently, an increasing number of ESOPs in the USA and Europe have been targeted at all employees instead of only at top management. This increased popularity of ESOPs targeted at all employees could be a result of shareholder interest or public criticism towards ESOPs targeted only at top management.2 Large target groups may lead to an increased free-rider problem since the connection between the output of each individual employee and the stock return becomes more vague. On the other hand, ESOPs could be used as part of a control system, where the importance of wealth increase for shareholders is highlighted through stock-based compensations. Previous studies have shown positive abnormal returns after the announcement of ESOPs targeted at executives (Tehranian and Waegelein, 1985; DeFusco et al., 1990; Yermack, 1997; Aboody and Kasznik, 1998) and in the long run (Tehranian and Waegelein, 1985).3 These papers offer divergent explanations for market reactions. Earlier papers by Tehranian and Waegelain (1985) and DeFucso et al. (1990) suggest that ESOPs targeted at executives motivate management to make superior decisions for shareholders. However, later studies offer evidence for managerial opportunistic behaviour through managing the timing of stock option awards (Yermack, 1997) or through the timing of news announcements (Aboody and Kasznik, 1998). The motivation argument is supported by the evidence that other types of long-range compensation plans for management also lead to an increase in shareholder wealth (Brickley et al., 1985). Furthermore,

1

See for example Carpenter and Yermack (1998), Greenspan (2002), Jensen and Fuller (2002), Conference Board (2002). 2 Finnish Gallup conducted a poll concerning the climate of working conditions on behalf of the Finnish Employee Association. The poll was conducted in August–September 1998 and covered the entire country except the Åland Islands. Sixty-seven percent of the respondents (1021 persons aged 15 or over were interviewed) consider employee stock options unfair and 76% think that the wageearners should get the same rise in wages as the executives. Source: L¨ ontagaren nr. 10/1998 (Vol. 28). 3 Leskinen (1998) conducted a study on the effects of stock option plans in Finland. According to his results, the announcement of a stock option plan was not associated with a stock market reaction in the short-horizon nor in the long-horizon. In his study Leskinen examined the market reaction on the day of a general meeting instead of the publication of the proposition or decision of the board of directors to introduce a stock option plan. Although the final decision is typically made at the general meeting, the information is already disclosed at the time of the proposal announcement. Therefore, at the general meeting there is a change in the uncertainty of disclosed information, whether the stock option plan is accepted as proposed or not (see, Salinger, 1992). In our study, we use the day when the proposal becomes public information as an announcement day. We expect that this is the day when new information is released to the market. This has been the most common practice while conducting an event study.

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companies that have adopted compensation packages that emphasize stock market performance perform better than other companies (Masson, 1971). Previous studies do not distinguish ESOPs that are targeted only at top management from those that cover all employees, although this could make a difference for shareholder wealth. According to the results by Huddard and Lang (1996) there is an indication that lower-level employees are less likely to commit themselves to stock option plans than higher-level employees. On the other hand, too generous ESOPs to top management may result in marginal wealth loss to shareholders. Therefore, the dilution effect is an important factor to consider in the analysis. If the motivational effect outweighs the dilution effect, then the result may be a positive market reaction, as seems to be the case in the USA. However, in the opposite case, the ESOP announcement may result in a negative market reaction. All these effects may be most relevant when companies adopt ESOPs for the first time. Firms that have once adopted a stock option plan seem to start granting stock options on a ‘regular’ basis. In this paper we examine the information content of ESOPs, i.e. (1) whether an ESOP announcement leads to changes in shareholder wealth; (2) whether an ESOP target group influences shareholder wealth; (3) whether the initial adoption of ESOPs conveys more relevant information than other ESOP announcements; and (4) whether dilution affects stock returns. Results suggest that an ESOP announcement will convey slightly negative information to the stock market, and that an initial ESOP adoption announcement leads to a significant negative signal to the market. Initial adoption announcements of ESOPs targeted at management result in insignificant positive stock returns, whereas ESOP announcements to all employees lead to significant negative stock market returns. A closer look at these initial announcements reveals that dilution has a negative impact on stock returns. The remainder of this paper is organized as follows. In the next section, Finnish environment and ESOP practices are described. Section 3 describes the data. In Section 4, event study methodology and results are presented. Section 5 presents regression analysis results and Section 6 concludes the paper.

2.

ESOPs IN FINLAND

The first Employee Stock Option Plan in Finland was issued in February 1988. Since then, the adoption of ESOPs in Finland has been rapid. The proportion of publicly traded companies on the Helsinki Stock Exchange (HEX) using employee stock option (ESO) plans increased from 6% at the end of 1990 to 63% in 1998.4 Altogether 90 ESOPs were organized up to 1998. Most ESOPs were targeted at top management (63) or key personnel (11) and only 16 at all employees (Fig. 1). During recent years, ESOs targeted at all employees have become more popular. The proposed reason for such popularity of ESOs comes from an increased international and institutional (i.e. investment funds and pension funds) ownership of 4 Similar trends could be found in the USA during the 1980s (Aboody, 1996), in UK in the late 1980s (Buck and Bruce, 1991), in Canada in the early 1990s (Klassen and Mawani, 2000), and in Germany in the late 1990s (Winter, 1999).

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Fig. 1. Number of ESOPs during the time period 1988 to October 1998 according to the target group. These ESOPs include all plans issued during the time period. Year is defined according to the announcement year.

Finnish publicly traded companies. At the beginning of 1993 foreign ownership restrictions were liberalized, and in July 1998 foreign ownership reached 50% of the total market value of HEX quoted companies. These investors are active traders5 and are ready to sell their holdings rather than use their voting power, should they disapprove of company actions. Hirvonen et al. (1997) argue that a transition from managerial and stakeholder capitalism into shareholder capitalism has occurred. This change in ownership structure accentuates problems of controlling managers and increases potential agency costs (Jensen and Meckling, 1976). One possible solution for ameliorating agency problems in Finnish companies comprises of ESOPs, which may suit the needs of distant owners who wish to control and motivate managers. Motivation plays an important role in companies, since a successful firm is generally characterized by motivated employees (Kjellman et al., 1996). Most stock option plans (76 out of 90) have a fixed striking price that is very close to the market value of stock near the day of grant. Ten ESOPs have a striking price that gradually increases and four ESOPs were indexed. The average maturity of options is 6.2 years (min. 2 years, max. 11.5 years). Compared to ESOPs in the USA, where an average time to expiration is 3 years (Kole, 1997), Finnish stock option plans have a longer maturity. An average proportion of new shares issued in ESOs to total quantity of stock of shares varied from 2.73% in the case of ESOPs targeted at executives and 3.19% (key personnel) to 6.80% in the case of ESOs targeted at all employees. 5

The share turnover in proportion to the market capitalisation of shares has increased from 15.2% (average from years 1990–1992) to 38.3% (1993–1995) and 45.9% (1996–1998).

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The Finnish tax treatment of stock option plans was changed in 1995. Prior to 1995, stock option plans were taxed as capital gains at execution. The difference between the stock market price and the exercise price was taxed. The tax bracket of capital gains (25%) was much lower than that of income tax for top executives (approximately 60%). Since then, all gains have been taxed as personal income with tax brackets of about 60%. The higher taxation may have caused the decrease in the amount of ESOPs in 1995 and 1996, but the tax effect seems to be only temporary. Therefore, the increased use of ESOPs since 1996 could not have been caused by taxation.6

3.

DATA DESCRIPTION

The original total sample in this study consists of 90 proposition announcements to issue stock options to employees made by Finnish companies listed at the time of the announcement on the main list of the Helsinki Stock Exchange from 1988 (February) to 1998 (October). The announcements were collected from Kauppalehti (a national daily business newspaper), the home page on the Internet of the Helsinki Stock Exchange (www.hex.fi), and by contacting the companies directly for further details. An event was accepted for our study if (1) the announcement clearly indicated to whom in the company the stock option plan is granted (all included); (2) the proposition was in printed form either by using a press release or a stock exchange release (all included); (3) the announcement date was clearly indicated (seven excluded); (4) the stock had been listed on the main list of Helsinki Stock Exchange for at least 200 trading days prior to the announcement day and 30 days after the announcement (12 excluded). By using these criteria, the total sample reduced to 71 announcements (see Appendix A). Most ESOPs were targeted at management (57) and only 14 were for all employees. In order to detect the stock market reaction to the stock option plan announcement, we examined whether some other relevant information was disclosed within the time period from 5 days prior to the announcement to 5 days after the announcement. If no other information was disclosed we included the announcement into our clean sample, otherwise the announcement was contaminated. In our sample, there are 29 clean announcements (26 targeted at management and three at all employees). All other announcements, 42 in total, included other information; in most cases either an earnings announcement and/or a dividend announcement. We were also interested in whether the information content differed between initial ESOP announcements and seasonal ESOP announcements. In our sample, there were 26 initial ESOPs targeted at management and nine at all employees. The sample structure is illustrated in Table 1. The average size of company total assets issuing ESOPs was 2.269 million Euros (median 675 million Euros). Companies issuing ESOPs targeted at management 6 Taxation has been proposed as one reason for using ESOPs. The longitudinal results in the US by Long (1992) support this argument, whereas the cross-sectional results in the US by Matsunaga (1995) and Yermack (1995) do not support tax argument.

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Table 1. Classification of ESOPs according to the type of announcement Clean

Initial Other Total

Contaminated

Total

Management

All empl.

Management

All empl.

Management

All empl.

12 15 27

2 1 3

14 16 30

7 4 11

26 31 57

9 5 14

Contaminated sample includes all ESOP announcements, clean sample includes only those announcements when no other information was disclosed within 5 days surrounding the ESOP announcement. Initial announcements includes only those announcements where the company first time indicates the adoption of stock options for any group of employees. Management includes those ESOPs targeted either to the management or to key personnel. All empl. includes those ESOPs where subscription right were not restricted inside the company to any specific group of employees.

(mean 2.265 million Euros and median 675 million Euros) were larger than those issuing ESOPs to all employees (2.096 million Euros and median 258 million Euros). When ESOPs are analysed according to business sector, we find the following differences: ESOPs seem to be commonly used in industries dealing in fields of metal and engineering, forestry, telecommunications and electronics, and chemicals. These are areas where companies compete on an international level; ESOPs are rare in local business areas such as banks and finance, insurance, investment, trade, energy, construction, media and publishing. A clear division between international and local companies infers that in the international business sector most ESOPs were targeted at management (26), and only six were targeted at all employees. In local business, seven were targeted at management and eight at all employees. All these facts show that the larger companies in international business sectors use ESOPs more often than their smaller local counterparts, and they are typically targeted at management, whereas their local counterparts direct ESOPs more often at all employees. The stock return data used for this study comprises the WI-Index database. The data has been adjusted for dividends, share issues and splits. The WI-index database contains a value-weighted logarithmic market index and logarithmic indexes for each individual company (see Berglund et al., 1983).

4. 4.1

EVENT STUDY METHODOLOGY AND RESULTS Methodology

In order to measure whether these stock option proposition announcements have signalling effects, i.e. convey information to the stock market, we calculate abnormal stock returns in the short horizon. We use two specifications, mean adjusted returns (MeAR) and market adjusted returns (MAR)7 (Brown and Warner, 1985; Strong, 1992). In order to measure the effects in the stock market, one-day, two-day 7

The market model was not applied since the returns will be biased if there is a run-up in prices prior to the announcement (de Roon and Veld, 1998).

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and five-day abnormal returns were calculated surrounding the announcement day. In this paper, only MeAR results are reported and MAR results are referred to only if they are different from the MeAR results. In our test statistics, we use the t-test, rank test and median-based sign test to test whether the results differ according to the test procedure (Corrado and Zivney, 1992). According to their simulation study, the rank test performs best when using daily return files of CRSP, while the t-test seems to have a tendency to reject the null hypothesis too often in the upper tail. Other simulation studies have shown that there are no major differences in calculation methods to detect abnormal returns either in the USA (Brown and Warner, 1985) or in thinly traded markets (Maynes and Rumsey, 1993).

4.1.1 T -test Let Ait represent the MeAR excess return of each security i on the one-day, two-day and five-day time interval. Each excess return is divided by its estimated standard deviation to yield standardized8 excess returns: Ait =

Ait S(Ai )

(1)

where the standard deviation of stock i is estimated by   n1 1   A2it S(Ai ) =  P

(2)

t=m1

where P is the number of returns available in the 220 day 9 period used to estimate the model parameters (220 returns for one-day returns, 110 returns for two-day returns and 44 returns for five-day returns). For the one-day excess returns, m1 is −250 and n1 is −31. Similarly, for the two-day returns m1 is −125 and n1 is −16, and for the five-day returns n1 is −50 and m1 is −6. Each number represents oneperiod, either one-, two- or five-day return period for the time period from day −250 to day −31. The test statistic for any event time period t is given by  A¯ t T1 =  S(A¯ )

(3)

where the average cross-sectional periodical average excess returns is calculated as Nt   1  Ait A¯ t = Nt

(4)

i=1

8

Excess returns were standardized in order to eliminate the dominating influence of more volatile stocks on the cross sectional results (see Patell, 1976). 9 For these cases where the comparison period started between the time period of −250 and −200, the amount of days was between 220 and 170.

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and where Nt is the number of sample shares whose excess returns are available at day t, and standard deviation is   n1 1     A¯ t2 (5) S(A¯ ) =  P t=m1

4.1.2 Rank test Let Kit represent the rank of the MeAR excess return Ait of each security is 281 day time series on the one-day, two-day and five-day time interval, Kit = rank(Ait )

(6)

where t = −250, . . . , +30. For the one-day interval, there are 281 return periods, for the two-day interval 140 return periods and for the five-day interval 56 return periods. These ranks are standardized by dividing by the number of non-missing returns, Uit =

Ki Mi

(7)

where Mi is the number of non-missing returns for each security. From each standardized series of individual security returns, the average10 of Ui is deducted:  Uit = Uit − U¯ i

(8)

The test statistic for any event time period t is given by T2 =

 U¯ t  S(U¯ )

(9)

 where U¯ t represents the average cross-sectional periodical rank of each excess return

Nt   1  U¯ t = Uit Nt

(10)

i=1

where Nt is the number of sample shares whose excess returns are available at day t and S(U¯  ) is calculated using the entire sample period of cross-sectional periodical excess return ranks:   n2 1    ¯ U¯ t2 (11) S(U ) =  P t=m2

10

Corrado and Zivney (1992) deduct 0.5 as an expected value. In our study we find that the expected value differs from 0.5 since there are several stock returns which are of same size. This is the reason for the expected value slightly different from 0.5.

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where P is the number of returns available: for the one-day interval P = 281, for the two-day interval P = 140 and for the five-day interval P = 56. For the one-day returns m2 is −250 and n2 is +30. Similarly, for the two-day returns m2 is −125 and n2 is +15, and for the five-day returns m2 is −50 and n2 is +6.

4.1.3 Sign test Let median(Ai ) represent the median excess return of security i for the time period of −250, . . . , +30. For each periodical return of the one-day, two-day and five-day time interval, the sign of each excess return is calculated as Git = sign(Ait − median(Ai ))

(12)

where sign(x) is equal to −1, 0 or +1 as x is negative, zero or positive. The test statistics for the sign test are based on the signs of Git S : Nt  (Git )

T3 =

i=1

(13)

S(G)

where S(Git ) is the standard deviation of entire sample period cross-sectional sum of signs:   2    n Nt  1 2  Git  (14) S(G) =  P t=m2

i=1

where P is the number of returns available: for the one-day interval P = 281, for the two-day interval P = 140, and for the five-day interval P = 56, and m2 and n2 represent return periods as in the rank test above. 4.2

Results

In this section we test whether the adoption of ESOPs results in an immediate wealth change among shareholders. The market reaction to the announcement is reported according to the MeAR model. Table 2 shows the test statistics of abnormal returns for stock option plans for all announcements. For all announcements of stock option plans (N = 71), we did not find any statistically significant stock market reactions when we used the MeAR model.11 This evidence holds for both contaminated and clean data as well as for ESOPs targeted at the management/key personnel or all employees.12 We could not find any significant differences between all ESOP announcements and clean announcements with any length of event windows. According to these results, ESOP announcements 11 Two exceptions were one-day positive stock return of all clean announcements tested with ranktest at 5% level and five-day negative stock return of contaminated announcements targeted to all employees tested with sign-test at 10% level. 12 The MAR-model gives less positive/more negative results than the MeAR-model.

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Two-day

Both target groups Contaminated (N = 71) Return 0.63 −0.17 t -test 0.99 −0.68 Rank-test 0.54 −0.15 Sign-test −0.42 0.24 Clean (N = 29) Return 0.40 −0.21 t -test 0.69 −0.62 Rank-test 1.39∗ 0.34 Sign-test 1.30 0.39 Target group is management or key personnel Contaminated (N = 57) Return 0.42 0.08 t -test 0.97 −0.43 Rank-test 0.83 0.20 Sign-test −0.16 0.56 Target group is all employees Contaminated (N = 14) Return −0.11 −1.21 t -test 0.39 −0.64 Rank-test −0.36 −0.70 Sign-test −0.59 −0.57

Five-day

0.09 −0.14 −0.58 −0.82 −0.08 −0.19 0.03 0.40

0.61 0.62 0.08 −0.13

−2.04 −1.34 −0.54 −1.82∗∗

∗ Statistically significant ∗∗∗ Indicates a statistical

at the 10% level. ∗∗ Statistically significant at the 5% level. significance at the 1% level. The stock market returns are measured by mean adjusted returns during the time period of one-day, two-day and five-day return periods after the announcements of ESOPs. Contaminated sample includes all ESOP announcements, clean sample includes only those announcements when no other information was disclosed within 5 days surrounding the ESOP announcement.

do not convey any relevant information to the share market. There seems to be neither positive nor negative stock market returns after disclosing the ESOP announcement. Next, we analyse the initial ESOP adoption announcements (N = 35) (Table 3). These results show the following differences. First, the contaminated sample seems to have an immediate positive impact on stock returns. Second, the clean sample indicates that initial ESOP adoption conveys negative information to the market within a two-day period. When different target groups are compared with all initial ESOPs, first, the initial ESOP adoption targeted at management seems to immediately positively affect stock returns within a one-day period. Second, ESOPs targeted at all employees have a statistically significant negative market reaction within the two- and five-day return period. According to these results, initial announcements convey more information to the stock market than other

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Table 3. Test statistics for the stock market reaction to stock option plans where the company first time indicates the adoption of stock options for any group of employees Mean adjusted returns (Announcements of ESOP for the first time) One-day

Two-day

Both target groups Contaminated (N = 35) Return 0.62 −0.40 t -test 2.00∗∗ −0.68 Rank-test 1.01 −0.70 Sign-test 0.00 −0.53 Clean (N = 13) Return −0.10 −1.94 t -test −0.54 −2.71∗∗∗ Rank-test −0.40 −2.00∗∗ Sign-test −0.66 −1.79∗∗ Target group is management or key personnel Contaminated (N = 26) Return 1.06 0.28 t -test 2.04∗∗ 0.03 Rank-test 1.48∗ 0.24 Sign-test 0.23 0.44 Target group is all employees Contaminated (N = 9) Return −0.14 −2.35 t -test 0.57 −1.49∗ rank-test −0.59 −1.85∗∗ sign-test −0.39 −1.75∗

Five-day

−0.27 −0.58 −1.01 −1.17 −2.43 −1.96∗∗ −1.73∗ −1.15

0.83 0.42 −0.24 −0.41

−3.43 −2.27∗∗ −2.09∗∗ −2.04∗∗

∗ Statistically significant at the 10% level. ∗∗ Statistically significant at the 5% level. ∗∗∗ Indicates a statistical significance at the 1% level. The stock market returns are

measured by mean adjusted returns during the time period of one-day, two-day and five-day return periods after the announcements of ESOPs. Contaminated sample includes all ESOP announcements, clean sample includes only those announcements when no other information was disclosed within 5 days surrounding the ESOP announcement.

announcements, and ESOPs targeted at all employees seem to convey negative information to the market. Conversely, ESOPs targeted at management or key personnel have an immediate positive affect on stock prices.

5.

REGRESSION ANALYSIS

In this section we examine whether the stock market reaction to ESOP announcements could be explained by the target group, the initial adoption of ESOPs and the number of new shares issued through the plan. In our analysis we have altogether

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65 announcements13 , of which 52 are targeted at management or key personnel and 13 are targeted at all employees. We used nonstandardized mean adjusted stock returns for this purpose because they help us to make financial interpretations of the results. The number of initial ESOP adoption announcements totalled 35, including 26 at management and 9 at all employees. For the target group we use a dummy variable D(man), which has a value of one when the ESOP is targeted only at management or key personnel. The dummy has a value of zero in the case of ESOPs targeted at all employees. For the initial adoption of ESOPs we use a dummy variable D(first), which has a value of one when the ESOP was introduced for the first time to the company. For other ESOPs, the value of this dummy is zero. Next we calculate a proxy for the wealth transfer from shareholders to employees. We used the following calculation to estimate the wealth transfer, since most ESOPs are issued close to the current market price or the subscription prices was not fixed: NEWSHARESi DILUTIONi = 100 ∗ OLDSHARESi where NEWSHARES represents the maximum number of shares which employees could subscribe with the issued options, and OLDSHARES indicates the total number of shares of the company at the time of the ESOP announcement. On average, the DILUTION for all ESOPs was 3.66% (median = 2.35%), for ESOPs targeted at management the mean dilution was 2.84% (median 2.16%), and for ESOPs targeted at all employees 6.79% (median 7.10%) respectively. The regression is initially modelled as MeAR = α + β1 DILUTIONi + β2 D(man)i + β3 D(first)i where MeAR is a cumulative mean adjusted return of one-day, two-day or five-day period, DILUTION is defined above, D(man) is one if targeted to management, or else zero, and D(first) is one if the initial adoption is disclosed, or else zero. In Table 4, the results are shown. Our first regression with the total sample of 65 cases indicates that ESOPs convey positive two-day stock returns (constant = 0.953, p-value = 0.122) when DILUTION is zero, but the DILUTION has a negative impact (p-value = 0.092) on market reactions. The D(man) has a negative but insignificant (p = 0.182) impact on stock returns. This indicates that, given a certain level of DILUTION, ESOP targeted at only a limited group of executives would convey less positive or more negative information to the stock market. Next we examine the clean sample of ESOPs. According to the regression where a two-day return is an independent variable, we find that D(first) has a negative impact on stock returns. This result and the results of Section 4 indicate that initial announcements convey more information than other ESOP announcements. Therefore we further analyse these initial announcements. Regressions with initial adoption filter, D(first) = 1, shows that with the twoday MeAR, the constant is 2.230 (p-value = 0.050), a regression coefficient of DILUTION is −34.405 (p-value = 0.026) and a regression coefficient of D(man) 13

Six cases had to be deleted since we did not have data for calculating the proportion of maximum number of new shares to the total number of current shares.

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Table 4. Cross-sectional regression of the one-, two- and five-day return periods after the announcements of ESOPs Independent variables Dependent MeAR

Filter

Constant

DILUTION

D(man)

Two-day

None

−13.738∗ (0.092)

−0.669 (0.182)

Two-day

Clean

Five-day

Clean

One-day

Initial

Two-day

Initial

Two-day

Initial

Two-day

Initial

Five-day

Initial

Five-day

Initial

Five-day

Initial

Two-day

D(man) = 0

Five-day

D(man) = 0

0.953 (0.120) 0.385 (0.125) 0.378 (0.126) 0.745∗ (0.077) 0.467 (0.246) 0.461 (0.397) 2.230∗∗ (0.050) 0.467 (0.205) −0.689 (0.156) 1.355 (0.198) 2.929∗∗ (0.046) 1.645∗∗ (0.023)

−10.310 (0.313) −15.125 (0.131) −34.405∗∗ (0.026) −16.986∗ (0.066) −26.698∗ (0.063) −44.994∗∗ (0.031) −31.089∗∗∗ (0.001)

0.466 (0.459) −1.573∗ (0.095)

0.772 (0.169) −0.792 (0.364)

D(first)

Adj. R square (%)

N

1.70

65

−1.09∗∗∗ 22.30 (0.006) −0.923∗∗ 16.90 (0.015)

29 29

0.20

32

4.40

32

−0.13

35

10.30

32

7.90

32

2.80

35

7.40

32

49.40

8

70.00

8

DILUTION is the proportion of new shares to be subscribed based on the ESOP to the amount of shares on the market at the time of the ESOP-announcement, D(man) is a dummy variable equal to one for ESOPs targeted to the management and zero otherwise, D(first) is a dummy variable equal to one for initial adoption of ESOPs and zero otherwise. p-values are in the parenthesis below the constant or multiplier. The responding significance levels are ∗∗∗ =1% level, ∗∗ =5% level and ∗ =10% level.

is −1.573 (p-value = 0.095). Similar results were obtained with the five-day periodical returns. When D(man) was regressed without the DILUTION, we could not identify any significant relationship (not reported in Table 2), whereas DILUTION seems to convey relevant information to the market. Therefore, we further split the sample into ESOPs targeted to all employees and to management or key personnel. These two groups were separately regressed and the results show differences in target groups. In the case of ESOPs targeted at management, the stock market reaction is not dependent on the size of DILUTION (not reported in Table 4), whereas in the case of ESOPs targeted at all employees, DILUTION plays the major role in explaining the stock market reaction. For the five-day event window, the constant was 1.645 (p-value = 0.023) and a regression coefficient of DILUTION was

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−31.089 (p-value = 0.006). This result should be interpreted with great caution due to the small sample size (N = 8). This difference in results between various target groups may be due to the differences in the absolute size of dilution. To summarize, ESOP announcements convey relevant information to the market. Most relevant announcements seem to be initial adoption disclosures where the firm indicates for the first time that a stock option plan is part of the compensation package of firm. This could be explained by the signal of decreased agency problems and the company’s interest to align changes of employee wealth to the owner’s interest. In principle, ESOPs seem to indicate that they motivate employees to make better decisions and work harder. For the ESOPs targeted at all employees this motivation effect loses its influence when dilution increases. This result indicates that stock markets anticipate future dilution at the time of an ESOP announcement.

6.

CONCLUSIONS

In this paper we have examined whether the adoption of stock option plans results in changes in shareholders’ wealth, and whether the stock market reaction to ESOP announcements could be explained by the target group of ESOP and the relative amount of new shares issued through the option plan. According to our results, ESOP announcements convey information to the market. Most information content seems to be in ESOP announcements that are initial adoption disclosures, i.e. when the firm indicates for the first time that a stock option plan is part of the compensation package of the firm. The results of regression analysis show that ESOPs with a low relative amount of new shares convey positive information to the stock market and the relative amount of new shares has a negative impact on stock returns. This was the case especially with ESOPs targeted at all employees, while stock markets seem to be insensitive to the relatively small number of new shares of ESOPs targeted at management or key personnel. These results could be explained by the higher average number of shares of ESOPs targeted at all employees and the danger of the free rider problem. Our results also indicate that the possibility of dilution has already been considered by the market at the time of ESOP announcement, and the market reaction is faster when larger international companies announce an ESOP to management. This study has assumed that ESOPs lead to increased motivation among employees resulting in better company performance in the future. The dilution effect represents the cost of motivating employees. For the moment, we do not know much about the interplay between these two factors. Further evidence, both at the aggregate and case level, would be important for understanding how various types of monetary incentives influence company performance.

ACKNOWLEDGEMENTS The authors would like to acknowledge the useful comments received on earlier versions of the paper presented at the XXI Symposium of Finnish Economists 8–9

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February 1999, Lappeenranta, the Joint Finance Research Seminar of the Swedish School of Economics and Helsinki School of Economics, 17 May 1999 and at the Annual Meeting of European Accounting Association in Munich 2000. We are especially thankful for the beneficial comments of Tom Berglund, Markku Kaustia, Juha Kinnunen, Eva Liljablom, Tomi Sepp¨al¨a and Mika Vaihekoski, and especially the reviewers of this journal. We gratefully acknowledge our financial supporters: Helsingin kauppakorkeakoulun tukis¨aa¨ ti¨ o, Jenny ja Antti Wihurin rahasto, Osuuspankkiryhm¨an tukis¨aa¨ ti¨ o and P¨ orssis¨aa¨ ti¨ o.

APPENDIX The final sample of ESOP announcements Company

Target group

Initial

Clean

New share(%)

Year

Amer1 Amer2 Asko Cultor1 Cultor2 Cultor3 Enso Finnlines1 Finnlines2 Finvest1 Finvest2 Finvest3 Fiskars Hackman Huhtamaki1 ¨ Huhtamaki2 ¨ Huhtamaki3 ¨ Huhtamaki4 ¨ Instru A KCI Konecranes Kemira Kesko Kyro Lassila&Tikanoja1 Lassila&Tikanoja2 Lannen ¨ Tehtaat Merita1 Merita2 Metra1 Metra2 Metsa-Serla ¨ Neptum Maritim1 Neptum Maritim2 Nokia1 Nokia2

Management Management Management Management Management Management Management Management Management Management Management Management Management Management Management Management Management Management Management Management Management Management Management Management Management Management All employees Management Management Management Management Management Management Management Management

Yes No Yes Yes No No Yes Yes No No No No Yes Yes Yes No No No No Yes No Yes No Yes No Yes Yes No Yes No No Yes No Yes No

No No No No No No Yes No No Yes Yes No Yes Yes Yes Yes Yes No Yes No Yes Yes Yes Yes Yes Yes No No No No No No Yes No No

2.34 3.49 2.13 1.30 2.17 2.15 0.96 2.35 2.61 7.17 3.24 10.42 n.a. 4.19 0.98 1.63 1.63 1.51 n.a. 2.00 2.21 1.50 n.a. 3.20 4.85 3.41 0.93 n.a. 0.58 0.40 2.16 2.20 2.84 0.29 1.94

1994 1998 1994 1992 1994 1997 1997 1994 1997 1989 1990 1996 1998 1998 1989 1991 1993 1997 1998 1997 1998 1996 1998 1993 1998 1997 1989 1997 1994 1996 1997 1993 1997 1994 1995 (Continued )

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Appendix Continued Company

Target group

Initial

Clean

New share(%)

Year

Nokia3 Nordic Aluminium OKO Orion Outokumpu Partek1 Partek2 PK Cables Raisio yhtyma1 ¨ Raisio yhtyma2 ¨ Rauma Rautaruukki1 Rautaruukki2 Raute Sampo Santasalo-JOT1 Santasalo-JOT2 Starckjohan Stockmann1 Stockmann2 Suunto Tamfelt1 Tamfelt2 Tamro1 Tamro2 Tamro3 Tieto-corporation1 Tieto-corporation2 Tieto-corporation3 Tulikivi UPM-Kymmene Vaisala Valmet1 Valmet2 YIT Ålandsbanken

Management All employees Management All employees Management Management Management All employees Management Management Management Management Management All employees All employees All employees Management All employees Management Management Management Management Management All employees All employees All employees Management All employees All employees Management Management Management Management Management Management All employees

No No Yes Yes No Yes No Yes Yes No No Yes No Yes Yes Yes No Yes Yes No No Yes No Yes No No Yes No No Yes Yes Yes Yes No No Yes

No Yes No Yes Yes Yes Yes No No No No Yes No No No Yes Yes No No Yes Yes Yes No No No No No No No Yes No No No Yes No No

3.17 6.50 1.87 6.72 2.09 0.91 2.60 7.58 1.34 2.84 2.08 0.83 1.95 n.a. 5.45 7.69 1.20 4.39 1.87 2.49 4.17 1.00 2.71 7.49 2.91 5.67 n.a. 9.65 2.27 2.76 2.22 2.45 1.41 2.56 4.10 12.50

1997 1998 1991 1998 1998 1994 1997 1998 1993 1998 1998 1994 1998 1998 1998 1997 1997 1997 1994 1997 1998 1989 1998 1994 1995 1997 1993 1996 1998 1997 1998 1997 1994 1998 1998 1998

Each row contains the following information: Company indicates the name of the company and the order number of ESOP in the company, Target group classified into management (management and key personnel) and all employees, Initial indicates whether the ESOP is the very first for the company (yes) or not (no), Clean indicates whether no other information concerning company, such as dividend, earnings, is disclosed within the time period of five days surrounding the announcement date (yes) or other information was disclosed (no), New share % indicates the dilution effect in percentage of the ESOP if it is fully exercised, Year indicates the announcement year of the ESOP.

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