Stock option compensation revisited : the effect of stock option compensation on firm performance in times of crisis

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University of Amsterdam Faculty of Economics and Business

Stock option compensation revisited: the effect of stock option

compensation on firm performance in times of crisis.

Chiel van der Zwan (10346937) Supervisor: dr. Ilir Haxhi

Second reader: dr. Johan Lindeque Master of Science in Business Studies Track: International Management

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List of Tables and figures

Table 1: Stepwise entry of model 2 ... - 32 -

Table 2: Stepwise entry of model 3 ... - 33 -

Table 3: Correlations and Descriptives 2005-2011 (excluding 2008) ... - 35 -

Table 4: Descriptives and correlations 2005-2007 ... - 36 -

Table 5: Descriptives and Correlations 2009-2011 ... - 37 -

Table 6: Regression on Stock Option Compensation ... - 40 -

Table 7: Regression on Tobin’s Q. ... - 42 -

Table 8: Regression on ROA. ... - 42 -

Table 9: Regression on Repricing (2005-2011). ... - 43 -

Table 10: Regression on Repricing 2005-2007 ... - 62 -

Table 11: Regression on Repricing 2009-2011 ... - 63 -

Table 12: Robustness Checks Model 1 ... - 64 -

Table 13: Robustness Checks Model 2 on ROA ... - 64 -

Table 14: Robustness Checks Model 2 on Tobin’s Q ... - 65 -

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Abstract

This research examines the relationship between stock option compensation and firm performance. Previous research extensively investigated the relationship between stock option compensation, its core predictors, repricing and firm performance but results remain inconclusive and uninvestigated in the context of the 2008 global financial crisis. I argue that, in spite of public and political scrutiny, stock option compensation has a positive influence on firm performance. Furthermore, I hypothesize that firm specific characteristics associated with agency problems, influence the use of stock option compensation. Lastly, I predict that lower financial firm performance leads to stock option repricings to restore incentive effects.

The results in this research indicate that stock option compensation is significantly negatively related to firm size and subject to industry effects. Furthermore, stock option compensation is positively related to Tobin’s Q, but not to ROA, indicating that stock option compensation incentivizes managers to focus on financial results (stock returns). Contrary to previous research, no evidence is found to support the hypothesis that lower firm performance in times of crisis leads to stock option repricings. In addition, no evidence is found indicating that capital structure influences stock option compensation.

Future research should incorporate firm size and industry type as controls when examining stock option compensation. Stock options seem to have the desired effect, enhanced firm performance, in terms of stock returns but not return on assets. This result remains robust during a financial crisis (2009-2011). Boards should take into account the stock return focus of managers that is induced when compensating through stock options. The results in this thesis indicate that stock option repricings in the 2008 global financial crisis were virtually non-existent. However, past research and the positive association between stock option compensation and financial performance, indicate it might be a valid method to restore incentive effects and performance. When repricing options, boards should consider possible political and public fallout.

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Acknowledgements

First and foremost I would like to thank my thesis supervisor, dr. Ilir Haxhi, for his support and valuable advice. In addition, I would like to thank Stephan Mol, Niccolo Pisani, Eloisa Federicia and Sofija Pajic for providing me and my fellow students with valuable advice and tips on research methods and academic writing, through their thesis workshop courses. Furthermore, I’m grateful to dr. Johan Lindeque.Last but not least I want to thank my fellow students and friends Jitteke van ‘t Hek and Rik Schuppers for helping me putting this thesis together.

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Preface

The 2008 global financial crisis left the world of business in a state of shock. How could this have happened? Who, or what, failed? What role did corporate governance play? And how can crises like this be prevented in the future? Much attention has been given to the role corporate governance played in the buildup of systemic risk, especially in U.S. financial institutions. How could these institutions have failed to the extent that the republican Bush administration, personified by secretary of finance Hank Paulson, was forced to spend billions of dollars on the saving of banks that where declared ‘too big to fail’?

Compensation schemes in U.S. public corporations received a lot of attention in the wake of the 2008 collapse. Did these compensation schemes led to short-terminism? How did owners fail to monitor managers? And how can this be improved? This thesis aims to investigate the agency problem that occurs from the separation of ownership and control in U.S. industrial firms. One way to address this agency problem is by the issuance of stock options to align owners and executive interests. One of the most important dimensions of differing interests is the natural risk aversion of managers. Stock options can enhance the risk appetite of managers to a level desirable but, arguably, also beyond desirable for shareholders. The questions addressed in this thesis, are especially interesting in light of the severe public and political scrutiny on compensation schemes in the wake of the financial crisis. Arguably, equity based compensation leads to highly paid executives and risk taking but, in line with a vast body of scientific research, it can also significantly enhance firm value.

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1 Introduction

The Anglo-Saxon system of corporate control rests on the separation of ownership and control of firms. This separation has many virtues since it exposes managers to low levels of risks while enabling investors to diversify risk over their portfolio. The system also has vices because the gap between managers and owners constitutes agency costs. Berk and DeMarzo (2011) view the corporate governance system as the tool to mitigate agency problems in the U.S. firm. Two broad approaches to address agency problems can be identified in the literature. First of all, shareholders appoint a board of directors to monitor the joint interests of shareholders since not a single owner has the incentive to monitor a firms management. The reason for this is that benefits of monitoring are divided among shareholders (Berk and DeMarzo, 2011). Secondly, shareholders can incentivize managers to act on their behalf through the use of compensation schemes. In the United States top executives in publicly traded firms are usually compensated through some mix of salary, bonuses, common stock, restricted stock and stock options (Bryan et al. 2000).

This thesis focuses on compensation through the use of stock options. The pay-performance sensitivity is significantly higher for stock option compensation than for common stock (Smith and Stulz, 1985; Jensen and Murphy, 1990; Lippert and Porter, 1997; Hemmer et al. 1999; Bryan et al. 2002). However, the literature remains largely inconclusive on the desirability of stock option compensation, its effects on performance and its relation to firm characteristics. Jensen and Murphy (1990) argued that stock option compensation significantly improves firm performance and that high compensation packages are simply the price to be paid for high firm performance. Since they wrote their groundbreaking article the pay-performance sensitivity of stock options (the dollar change in CEO wealth for a dollar change in firm value) has risen from 3,25/1000 dollar to 25/1000 dollar (Hall and Liebman, 1998). Throughout the 1990s and 2000s stock options have remained one of the core components of compensation in publicly traded U.S. firms (Berk and DeMarzo, 2011). However, contrary to the results obtained by Hall and Liebman (1998) and their theoretic basis (Jensen and Meckling, 1976; Jensen and Murphy, 1990), a number of authors find no relationship between firm performance and stock option compensation (Himmelberg, 1999; Palia, 2001). In addition, a number of authors find a negative relationship or some sort of other relationship such as W-shaped or convex (Cui and Mak, 2002). Cui and Mak (2002), argue that the different results obtained in different studies might be due to firm characteristics many researchers fail to control for. The different samples used in different studies would than lead to different results.

The 2008 financial crisis caused severe public and political scrutiny on compensation schemes in the United States. One of the core building blocks of agency problems in the U.S. firm is the natural risk

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aversion of executives. Without mitigation executives theoretically refrain from making risky investments with a positive net present value, and thus investments in the best interest of shareholders (Dong et al. 2010). Awarding stock options to executives would leave them more inclined to make these risky investments because stock options act as a performance dependent bonus tight to the firms share price (Dong et al. 2010). Dong et al. (2010) and Boatright (2009) argue however, that it can also enhance executive risk appetite beyond the level desirable for shareholders. This is also one of the core criticisms of the general public on compensation schemes in the U.S. in the context of the global financial crisis and other accounting scandals such as Enron. The relationship between stock option compensation and stock option repricings was previously investigated by Saly (1994) in the context of the financial crisis of the late 1980s. She found that compensation schemes should consist of base salary and stock option compensation because this enhances firm performance. In addition, she found that boards tend to reprice stock options to restore incentive effects after a market downturn. Repricing refers to changing the exercise price of outstanding out of the money stock options, usually to the current share price. If stock options are significantly underwater they lose all incentive effects. When stock options are underwater because of a performance decline over which management had no control, usually because of adverse market conditions, boards can decide to reprice stock options to restore incentive effects (Saly, 1994). Previous literature found mixed effects of stock option compensation on firm performance and this relationship was not investigated in the context of the 2008 global financial crisis, in spite of severe public criticism. I line with Cui and Mak (2002), I argue that the mixed effects found in previous literature stem from differences in sample and the wrongly assumed exogeneity of stock option compensation. To test this argument I investigate the relationship between firm characteristics such as size, industry type and capital structure and stock option compensation. In addition, I think the relationship between stock option compensation and firm performance differs not only with firm characteristics but also with market conditions. Theoretically, the same experiment might yield a positive relationship in some years and a negative relationship in other years. This notion could help to explain the different results obtained in previous investigations. The rationale behind this argument is as follows: stock option compensation induces risky behavior with extra positive results in a market upturn, but with significantly less positive results in a market downturn. To test for this effect I investigated the relationship between stock option compensation and firm performance pre- and post-crisis (proxied by the time periods 2005-2007 and 2009-2011). Furthermore, I hypothesize that the relationship between stock option compensation and firm performance differs with the performance measure used. Theoretically, stock option compensation leaves managers focused on stock prices. Following this rationale, the pay-performance sensitivity should be larger for financial

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performance measures than for non-financial performance measures. To test for this effect I ran regressions using both Tobin’s Q (Q, a financial performance measure) and return on assets (ROA, a non-financial performance measure). Lastly, in line with Saly (1994) I revisited the relationship between firm performance and repricing. Saly (1994), found that after a market downturn corporate boards tend to reprice stock options to restore incentive effects. In addition, she found that repricing lead to additional (or restored) firm performance. This yields support for the use of stock options and even for issuing additional stock options in a market downturn. Given the public debate on compensation schemes and the changed market dynamics, I test if firms still tend to reprice after firm performance is adversely affected by market conditions beyond executive control.

In sum, a number of relationships surrounding stock options is tested in this research. First of all, in line with Cui and Mak’s (2002) argument I test if firm characteristics influence stock option compensation. This could explain the different results obtained in previous research. Secondly, I hypothesize there exists a positive relationship between stock option compensation and firm performance. In addition, I argue that the strength and direction of this relationship differs with different market conditions. To test for market conditions this test will be conducted in the context of the 2008 financial crisis. In addition I will use two different performance measures. Theoretically, the pay-performance sensitivity should be larger for Tobin’s Q because of its relation to the firm’s stock price. Lastly, I revisited the relationship between firm performance and repricing. Theoretically, lower firm performance should lead to the issuance of more new stock options because of repricing considerations. In addition, this relationship is argued to be moderated by R&D intensity. The rationale behind this notion is that R&D intensive firms are associated with higher stock volatility, a bigger investment opportunity set and larger agency problems (Cui and Mak, 2002). Therefore, R&D intensive firms should be more affected by the crisis and in need of more mitigation of agency problems.

The results obtained in this research indicate stock option compensation depends on firm size and industry type but not on capital structure. 10% of the variation in the model is explained by these variables and therefore there are possibly more firm characteristics influencing the use of stock option compensation. Secondly, there exists a positive relationship between stock option compensation and financial performance (proxied by Tobin’s Q). No relationship can be found when using ROA. The positive relationship between stock option compensation and firm performance exist both pre- and post-crisis but is stronger pre-crisis. From this result it can be inferred that market conditions affect the relationship between stock option compensation and firm performance, which helps to explain some of the variation in previous results. In addition, stock option compensation seems to leave managers focused on financial performance but not so much on other forms of

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performance. No relationship can be found between firm performance and repricing. This indicates a change in context compared to the 1980s.

Future research should incorporate firm characteristics when investigating stock option compensation. Furthermore, future research should take into account the environmental (market) effects prevalent in the time there research is conducted. Corporate boards should not only consider the incentive effect stock option compensation has, but also the form of performance on which this incentives have the most effect. In addition, corporate boards could reconsider repricing as a way to restore firm performance after a market downturn. Results indicate repricing has become virtually obsolete in the current day and age, probably due to public scrutiny on compensation schemes. However, Saly (1994) found positive effects of repricing indicating it can be worthwhile.

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2 Literature Review

This chapter will review the relevant literature on corporate governance and executive compensation. First I will discuss core concepts of stock option compensation, then I will summarize the research gaps and delineate several hypotheses about the relationship between stock option compensation and firm performance and firm performance and repricing and in the final section I will develop a conceptual framework.

2.1 Core Concepts

Corporate Governance

‘Corporate governance can be defined broadly as the study of power and influence over decision making within the corporation’ (Aguilera and Jackson, 2010 p. 487). In the words of Aoki (2000), corporate governance deals with the structure of rights and responsibilities of all stakeholders. Berk and DeMarzo (2011), define corporate governance as the system of controls, regulations and incentives designed to prevent fraud. They view corporate governance as being about mitigating conflicting interests. Koen and Mason (2005), state that effective corporate governance rests on two pillars. Namely, the ability of owners of a corporation (shareholders) to effectively monitor and, if necessary, intervene in the operations conducted by management on the one hand, and the effectiveness of the market for corporate control to vest monitoring tasks in those owners best capable of carrying it out on the other hand. Corporate governance systems widely vary across institutional contexts. The literature on corporate governance usually distinguishes two broad models of corporate governance, the Anglo-Saxon, shareholder, outsider or market-based model and the stakeholder, Rhineland or insider model (Aoki, 2000; Aguilera and Jackson, 2003; Koen and Mason, 2005; Aguilera and Jackson, 2010). Recently, emerging markets are increasingly recognized as the third global system of corporate governance (Epstein, 2012).

The Rhineland model of corporate governance is characterized by a two-tier board system, bank based financing, the use of a civil law legal system, moderate levels of disclosure, moderate pay incentives and its focus on stakeholders, not just shareholders (Koen and Mason, 2005; Epstein, 2012). This system is most prolific in Scandinavia, Germany and Japan (Epstein, 2012). The emerging markets system is, logically, found in countries such as China, India, Brazil, Russia and the countries of Eastern-Europe (Epstein, 2012). This system is characterized by a stakeholder focus, relatively weak legal systems, low levels of disclosure, small pay incentives, a focus on family and government for financing and a varying board structure with few outside board members. This thesis, however, focuses on U.S. S&P 500 firms.

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The shareholder model of corporate governance is associated with Anglo-Saxon countries, most notably the U.S. and the U.K. It is associated with a strong shareholder focus, financing through markets, a unitary board structure, the use of a common law legal system, high level of and many rules on disclosure and large pay incentives (Epstein, 2012). Interesting in light of this thesis is the pay for performance structure used in many U.S. firms (Epstein, 2012). In this model the maximization of shareholder value is the goal of the firm and shareholders enjoy strong links with top management (Koen and Mason, 2005). The Anglo-Saxon model is associated with equity financing, dispersed ownership and active and flexible markets for labor and corporate control (Aguilera and Jackson, 2003). Since ownership of corporations under the Anglo-Saxon model is dispersed, owners mostly discipline managers through the use of an ‘exit mechanism’. This entails that, because multiple owners cannot coordinate their disciplinary efforts to maximize combined profits, they trade competitively (Edmans and Manso, 2008). According to Edmans and Manso (2008), trading impounds information in share prices, which makes the threat of disciplinary exit credible and thus enhances managerial effort.

In addition to the competitive trading scheme, dispersed owners of U.S. firms appoint a corporate board to look after their interests. In firms with widely held ownership, not one owner has the incentive to bear the costs of monitoring since the benefits of monitoring are divided among all owners (Berk and DeMarzo, 2011). U.S. boards have as a core responsibility the protection of shareholders interests whereas, in other institutional contexts, some weight usually is given to the interests of other stakeholders (Fiss, 2008).

A core goal of corporate governance systems is the mitigation of agency problems between shareholders and managers of the firm. In the economics and management literature, agency theory deals with the information asymmetry between management (the agent) and owners (the principal) of a firm. It deals with the way in which owners assure themselves of a return on their investment (Shleifer and Vishny, 1997). At the very core of the agency perspective lies the alignment of management and owners interests, given the separation of ownership and control of firms (Eisenhardt, 1989; Tosi and Gomez-Mejia, 1989; Koen and Mason, 2005; Aguilera and Jackson, 2010, Berk and DeMarzo, 2011). In the next section the agent-principal problem will be discussed in more detail.

Agency Theory

At the core of the agency problem lie the problems associated with motivating one party (the agent), with more information, to act in the best interest of another party (the principal). The problem can be found everywhere where there is a principal-agent relation. Examples include politicians (the

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agent) and voters (the principal) in political science, and corporate management (the agent) and shareholders (the principal) in economics and management science (Bebchuck and Fried, 2004). The managerial agency problem arises when managers and shareholders have different interests and there is asymmetric information (Jensen and Meckling, 1976; Eisenhardt, 1989; Bryan et al. 2000; Berk and DeMarzo, 2011). Agency problems notably occur in the natural risk aversion of managers. Managers are naturally risk averse leading them to abstain from risky investments that would enhance firm value and thus be in the best interests of shareholders (Jensen and Meckling, 1976; Chen and Ma, 2011).

The gap between owners and managers interests constitute agency costs. Agency costs are cost incurred by the principal to motivate the agent to act in the principals best interest (Jensen and Murphy, 1990; Bebchuck and Fried, 2004). Jensen and Meckling (1976), define agency costs as the sum of monitoring expenditures incurred by the principal, bonding expenditures incurred by the agent and residual loss. Monitoring expenditures are incurred when the principal establishes incentives for the agent to act on its behalf. Bonding expenditures are costs put upon the agent by the principal to insure the agent will not diverge from its interests. Since neither the principal nor the agent is able to insure the best actions from the principals perspective are taken at zero costs some residual loss always occurs (Jensen and Meckling, 1976).

In business, agency problems occur because of the separation of ownership and control in firms. This separation has many virtues (Berk and DeMarzo, 2011). It enables investors to hold an ownership stake in any firm, giving them the opportunity to diversify risk. At the same time, it does not require managers to be owners which reduces their risk exposure to much lower levels than it would be without this separation (Berk and DeMarzo, 2011). However, the agency problem arises any time managers do not internalize the cost of their actions or bear the risks (Berk and DeMarzo, 2011). Berk and DeMarzo (2011), view the role of the corporate governance system purely as to mitigate the agency problem between managers and owners of the firm. In their view the core goal of corporate governance is the alignment of owners and managers interest without exposing managers to too much risk. In addition, the corporate governance system should align the principal and agents interests at the lowest possible agency costs (Jensen and Meckling, 1976).

One way to mitigate agency problems is through close monitoring by the board. A board is appointed by shareholders to monitor managers. Since the benefits of monitoring executives are divided among shareholders, no single shareholder has the incentive to bear all the costs associated with it (Berk and DeMarzo, 2011). Through monitoring, managers are forced to act in the best interest of shareholders but their financial interests may still not be aligned.

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To align managers and shareholders financial interests companies can use performance related compensation. By compensating managers with the use of common stock or stock options (equity pay), managers become shareholders. The heavily debated relationship between firm performance and equity based compensation has, thus far, yielded inconclusive results (Jensen and Meckling, 1976; Jensen and Murphy, 1990; Hall and Liebman, 1998; Bryan et al. 2000; Chance et al. 2000; Acharya et al. 2000; Corrado et al. 2001; Carter and Lynch, 2001; Murphy, 2002; Yang, 2002; Wu, 2009; Aboody et al. 2010; Chen and Ma, 2011; Berk and DeMarzo, 2011).

Jensen and Meckling (1976), define an agency relationship as a contract under which the principal delegates decision making power to the agent to perform a service on its behalf. Because both parties are generally utility maximizers the agent will not necessarily take actions in the best interest of the principal. To mitigate this problem principals can establish incentives for the agent to act on its behalf.

Mitigation through Compensation

As described in previous section there are generally two ways to mitigate agency problems between managers and owners of a firm. On the one hand owners can control managers and mitigate the agency problem through close monitoring by a board of directors. Alternatively, executives compensation can be tight to performance (Jensen and Meckling, 1976; Jensen and Murphy, 1990; Hall and Liebman, 1998; Bryan et al, 2000; Aboody et al. 2010; Berk and DeMarzo, 2011; Chen and Ma, 2011). Since the 1990s, the use of performance related pay has gained importance in U.S. firms (Berk and DeMarzo, 2011).

Performance related pay can take a variety of forms such as bonuses for earnings growth or a broad range of equity-based payment schemes. Authors such as Hall and Liebman (1998) and Jensen and Murphy (1990), argue that tying compensation closer to performance has many virtues and high compensation packages are simply the price to be paid for high firm performance. Since Jensen and Murphy (1990) wrote their groundbreaking article, U.S. firms have shown a tendency to adopt compensation policies that gave managers a direct ownership stake in firms through the issuance of common stock or stock options (Berk and DeMarzo, 2011). According to Hall and Liebman (1998), this caused the pay-performance sensitivity (the dollar change in CEO wealth for a dollar change in firm value) to increase from $3,25/$1000 to $25/$1000 between 1990 and 1998. The rationale behind equity based compensation is as follows: linking executive compensation to the firms’ stock price leaves managers more inclined to increase that stock price, which is in the best interest of the firms’ owners (Chen and Ma, 2011). However, much scientific debate exists on the

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compensation-- 15 compensation--

performance relationship and the virtues and vices of tying pay to performance through equity-based compensation.

Three bodies of scientific literature on equity-based compensation can be identified: literature focusing on the characteristics and determinants of equity-based compensation, literature focusing on the relation between equity-based compensation and firm performance and literature that investigates the components of equity-based compensation (Chen and Ma, 2011).

Characteristics and Determinants of Equity-Based Compensation

Bryan et al. (2000) investigate the relationship between the incentive intensity provided by stock options and the mix of stock option awards to cash compensation in U.S. firms. They find that the level of stock option compensation varies with noise, the level of CEO stock ownership, and leverage. In addition, they find that stock option compensation is more suitable to mitigate agency problems in high-growth (R/D) firms, because the convex payoff structure will incentivize managers to take on risky but positive net present value projects sooner. Wu and Tu (2007), also investigate the relationship between stock option compensation and R/D spending. They find that this relationship depends on general firm performance and slack resources. Specifically, they find the relationship to be more positive when firm performance is high and a firm possesses more slack resources. Gaver and Gaver (1993), in addition, find a positive relation between firm’s growth, associated with R/D spending, and equity-based compensation. Firth et al. (2007), find a positive relationship between profits and CEO compensation. Furthermore, higher ownership concentration is associated with lower levels of overall compensation, higher ratio’s of salary to total compensation and lower ratio’s of options to total compensation (Khan et al. 2005). In general, Khan et al. (2005) find that higher ownership dispersion leads to higher levels of incentive compensation. This result seems logical because larger ownership dispersion leads to bigger monitoring problems (Berk and DeMarzo, 2011). According to this first body of equity-compensation literature, the most important factors related to equity-based compensation are stock market return, firm size, R/D spending, corporate payout policy, capital structure, (institutional) ownership dispersion and leverage. Contrary to these authors a vast body of research investigating stock option compensation assumes it to be exogenous (Morck et al. 1988; McConnell and Servaes, 1990; Short and Keasy, 1999; Cui and Mak, 2002). Given the determinants of stock option compensation described above this assumption might be problematic.

Equity-Based Compensation and Firm Performance

Equity-based compensation is used to mitigate agency problems between managers and owners. The principal interest of shareholders is firm performance, in the form of stock returns, whereas managers can have different or additional interests. Based on this rationale, there should be a

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(positive) relationship between equity-based compensation and firm performance. The second body of literature investigates this relationship.

Mehran (1995), finds a positive relationship between incentive (equity-based) compensation and firm performance. In addition, both the form and the level of compensation are important in determining firm value (Mehran, 1995). In line with these results Ittner et al. (2003) find that lower than expected grants or holdings of existing options lead to poorer firm performance in subsequent years. Conversely, Florackis et al. (2009), find a positive relationship between firm performance and equity compensation only at low levels of managerial ownership, indicating that higher levels might not be desirable for shareholders. Richardson and Waegelein (2002), find that firms with long-term performance plans usually have higher levels of institutional ownership and lower levels of managerial ownership but perform better regardless. Himmelberg et al. (1999) conclude that, when controlling for firm characteristics and firm fixed effects, changes in managerial ownership do not affect firm performance. Palia (2001), also finds no direct association between managerial ownership and firm performance. Clearly, the literature is inconclusive on the relationship between firm performance and equity based compensation.

Core arguments underlying equity-based compensation include the enhancement of risk appetite of managers (Carpenter, 2002) and retention or attraction of key personnel (Hubbard and Palia, 1995; Ittner et al. 2003). On these virtues of compensation the literature remains inconclusive as well. Chen and Ma (2011), find that equity compensation does increase risk taking, while Carpenter (2002) finds this is not necessarily the case. Ittner (2003), only finds that employee retention objectives influence new hire but not subsequent grants. Dong et al. (2010), conclude that stock option compensation leads managers to take on more risk. In addition, Dong et al. (2010) find that stock option compensation can lead managers to take on too much risk.

Components of Equity-Based Compensation

The most basic division in components of equity-based compensation can be made between the issuance of common stock and stock options (Berk and DeMarzo, 2011). In addition, stock or stock options can be issued under a wide variety of restrictions such as vesting periods.

Contrary to the pay-performance relationship and determinants addressed in the previous sections the literature largely agrees on the incentive effects of the different components. The pay-performance sensitivity is significantly larger for stock options than for common stock (Smith and Stulz, 1985; Jensen and Murphy, 1990; Lippert and Porter, 1997; Hemmer et al. 1999; Bryan et al. 2002). Therefore, option compensation plays a bigger part in addressing the relationship between

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firm performance and equity-based compensation. This research focuses on stock option compensation, the next section addresses stock option compensation in more detail.

Stock options

Performance related pay can take many forms, such as bonuses for earnings growth, common stock issuance and stock option compensation. This research focuses on the use of stock options as compensation for managers in the United States. Stock options give the holder the right to either buy or sell a stock on or before a given date for the exercise price (Berk and DeMarzo, 2011). A distinction is made between put options (graph 2), which give the holder the right to sell stock at or before a future date, and call options (graph 1), which give the holder the right to buy stock at or before a future date (Berk and DeMarzo, 2011). Options can be either at the money, which means the underlying stock is worth as much as the exercise price, in the money, which means exercising the option will yield a positive result, or out of the money. Call options that are out of the money have an exercise price above the stock price. Consequently, out of the money call options do not get exercised and yield a result of 0 (see graph 1) (Berk and DeMarzo, 2011). In addition, a distinction can be made between American and European style options. American options give the holder the right to exercise the option on any date up to the expiration date, European options give their holder the right to exercise the option only on the expiration date (Berk and DeMarzo, 2011).

Graph 1: Call Option Payoff Graph 2: Put Option Payoff

Jensen and Murphy, in their 1990 article, laid the foundation for tying compensation more closely to firm performance by the issuance of stock options. Executives are issued call options, which give them the right to buy stock at or before some date in the future. Typically executives are awarded some mix of European and American style options, in which the options can be exercised before the expiration date, but are subject to a vesting period of three to five years after issuance (Jensen and Meckling, 1976; Haugen and Senbet, 1981; Agrawal and Mandelker, 1987; Lambert et al. 1991; Smith and Watts, 1992; Chance et al. 2000). When executives manage to create additional firm value the stock becomes worth more than the exercise price of the option. It finishes in the money and managers are able to buy stock at a lower than market price in the future. The difference between

0 20 40 0 20 40 60 Pay o ff ($) Stock Price ($) 0 20 40 0 20 40 60 Pay o ff ($) Stock Price ($)

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the exercise price and the actual share price acts as a bonus directly tight to shareholder value creation (see graph 1). Jensen and Murphy (1990), argue that compensation through stock options helps to overcome the agency problem between managers and owners. This view is all but new, as early as the 1930s, the economic rationale for the use of equity-based pay has been that it can help to align the interests of managers and owners, and thus helps to overcome the principal-agent problem that stems from the separation of ownership and control common in most public corporations (Berle and Means, 1933). Jensen and Murphy (1990), view the resulting high compensation packages as the price to be paid for the creation of firm value.

According to Murphy (1999), the use of stock options in executive compensation packages has grown enormously over the 90s. Since the 90s this form of equity-based pay has remained an important part of executive compensation in the United States (Dong et al. 2010). The literature is inconclusive on the desirability of stock option compensation as a means to align interests. The main argument against stock option compensation is that it leaves managers less able to balance the interest of various stakeholders. Boatright (2009), even goes as far as to state that stock option compensation changed executives from risk-neutral semipublic servants to leaders without concern for the good of society as a whole. Where Jensen and Murphy`s (1990) article has its roots in the principal-agent view of the firm, Boatright (2009) offers as an alternative explanation of the firm the team production model. In this model the idea that teams are better able to produce wealth than individuals is central, CEO`s should balance these teams and divide their surpluses. Large shareholdings however, can lead to block control by executives, entrenchment, private benefits extraction, perverse behavior, and managerial myopia (Dong et al. 2010). A diversity of studies even show that especially stock option holdings lead to manipulation of corporate earnings and accounting fraud, which leads to inflated stock prices and thus to managerial profit when stock options are exercised (Dong et al. 2010).

A widespread form of manipulation is backdating of stock options (Heron and Lie, 2007). Backdating refers to altering the date a stock option was granted, it is an illegal form of repricing and brings additional profits to stock options with a strike price tight to the stock price at the issuance date (Berk and DeMarzo, 2011). Resetting the date of issuance to a date at which the stock price was lower obviously widens the gap between the strike price and current stock price and thus inflates the ‘bonus’ portion of an option.

One of the most important dimensions of agency problems between shareholders and managers is the natural risk aversion of executives. Shareholders hold diversified portfolios, whereas managers have undiversified portfolios and are bothered by organization specific human capital (Dong et al.

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2010). Stock options can then be granted as compensation to induce more risk taking by managers who otherwise might not make risky investments with a positive net present value (and thus investments in the best interest of the shareholders). Although, whether stock options indeed induce more risk taking depends on a lot of other option characteristics and personal manager characteristics like outside wealth and personal risk aversion, managers do seem to be responsive to this incentive (Dong et al. 2010). However, Dong et al. (2010) prove in their study that it is possible that managers take on risk beyond the level desirable for shareholders. Dong et al.(2010) state that these findings, and those of other authors (Lambert, 1986; Ju et al. 2003; Bebchuk and Fried, 2003; Raviv and Landskroner, 2009) that investigated call option contracts, add up to the popular public opinion that firms where executives received considerable stock option packages contributed to, for example, the demise of Enron in 2001 and the 2007-2009 financial crisis. The rationale behind this notion is that stock options encourage excessive risk taking and overleveraging (Dong et al. 2010). Stock option compensation has received a lot of criticism in the wake of the 2008 global financial crisis. Arguably it played a big part in the pursuit of short-term value creation instead of long term value building. This research aims is to revisit the relationship between executive stock options (ESO) as compensation and firm performance. This relationship will be investigated against the background of the global financial crisis. This relationship was investigated extensively but results remain inconclusive. Furthermore, the relationship between ESO’s and firm performance is yet to be investigated since the global financial crisis sparked severe public and political scrutiny on the phenomenon.

A number of previous articles assume managerial ownership is exogenous (Cui and Mak, 2002). However, Cui and Mak (2002) state that such an assumption might be problematic since other articles find that stock ownership might depend on a number of firm and industry characteristics. Among these other factors are firm size, industry, the regulatory environment, capital structure and the investment opportunity set (Demsetz and Lehn, 1985; Smith and Waths, 1992; Gaver and Gaver, 1993 and Himmelberg et al. 1999).

The previous sections exhaustively described the rationale behind stock option compensation. This logically yields a few core predictors of stock option compensation because they are inherent to agency problems. According to the literature that does recognize the probable endogeneity of stock option compensation, the most important predictors of agency problems, and thus stock option compensation are capital structure, industry type and firm size (Bryan et al. 2000; Gaver and Gaver, 2003; Khan et al. 2005; Wu and Tu, 2007; Firth et al. 2007; Berk and DeMarzo, 2011; Chen and Ma, 2011).

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The severe scrutiny from regulators and the public at large on stock option compensation since the global financial crisis might, however, have changed the dynamic behind these relationships. Since the relationship between these predictors and stock option compensation hasn`t been investigated in firms since the crisis took effect this thesis will revisited it.

Repricing

Compensation through stock options has as its main purpose the alignment of executives and owners interests. As explained in previous sections the difference between strike price and future stock price acts as a performance dependent bonus. Managers are incentivized to increase shareholder value because they are shareholders themselves. However, when stock prices lie significantly below the exercise price of executives options (they are underwater), they lose all worth and can no longer act as performance motivators. In this case, boards can decide to reprice outstanding stock options in a variety of ways (Chance et al. 2000; Acharya et al. 2000; Corrado et al. 2001; Carter and Lynch, 2001; Murphy, 2002; Yang, 2002; Wu, 2009; Aboody et al. 2010). According to Chance et al. (2000), the rationale behind repricing is that if a company performs poorly because of market conditions outside of the executives control, they need not be punished for this poor performance and motivation can be renewed by repricing the options. Repricing usually involves changing the exercise price of option packages to the (as an effect of market conditions lower) current stock price (Chang et al. 2000). Conversely, but mostly theoretically, if firms perform well because of good market conditions, a repricing can occur to not reward management for a performance increase caused by conditions over which management had no control (Saly, 1994).

Traditional repricing refers to the change of exercise prices of underwater stock options currently owned by management, to exercise prices that reflect the current market value (Yang, 2011). This form of repricing was the most common form in the United States, until a change in U.S. accounting rules in 2000 caused companies to take a variable charge to earnings for repriced options. Yang (2011), investigates alternative repricing methods that occurred since the new rules took effect. Alternatives are the cancellation and reissuance of underwater options, the granting of new options upfront in exchange for the surrender of old options, reducing the exercise period and letting the options expire without cancellation if their value falls below a predetermined level, hand out more options at a lower exercise price while leaving underwater options outstanding, grant restricted stocks or grant restricted stock in exchange for underwater stock options (Yang, 2011). The rationale behind repricing is that managers can be remotivated by it after a stock value decline caused by external market forces not related to managerial performance occurs. This occurred on a large scale in 2008 because of the global financial crisis.

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The effect of a market downturn on option contracts and repricing has been investigated by Saly (1994), with the crisis of the late 1980s as a background. In Saly`s (1994) research, repricing is indirectly investigated by measuring the reissuance of new stock options after the crisis, both in total number of stock options granted as in total stock value. Since 2000, the practice of repricing options by resetting the exercise price on outstanding stock has become obsolete. Since then firms always have to reprice using one of the methods mentioned by Yang (2011), to avoid a variable accounting charge. All of this methods involve the issuance of new stock option packages, indicating that the method used by Saly (1994), should be more robust now than it was in 1994, when repricing by resetting exercise prices on existing stock was still a valid, and the most common, method of repricing. (IN METHODS?)

In 2008, massive stock value declinations occurred for companies throughout the United States. A lot of this decline in value, especially in non-financial institutions, occurred because of rapidly deteriorating market conditions that beyond executive control. This value declination was more severe in companies that took on too much risk, to which stock option compensation can have contributed. The relationship between repricing and firm performance was previously investigated by a variety of authors but results remain inconclusive. In addition, because of its effect on market conditions it is especially interesting to investigate repricing in light of the financial crisis and the severe public and political scrutiny the crisis sparked on compensation schemes.

Research and Development

Cui and Mak (2002) investigated the relationship between firm performance and stock option compensation in high R/D industries. They argue that the investment opportunity set and volatility are higher for executives in high R/D firms. Therefore, agency problems are bigger and there’s a higher need for agency problem mitigation. In addition, given their distinct firm characteristics high R/D firms might rely more on ownership than on board governance to mitigate these problems (Cui and Mak, 2002). Furthermore, the relationship between R/D intensity and stock option compensation has not been investigated in the large industrial firms on which this thesis focuses, only in smaller firms in high R/D industries (Himmelberg et al, 1999; Cui and Mak, 2002).

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2.2 Hypotheses Development

Predictors of Stock Option Compensation

The literature on the main predictors of stock option compensation remains inconclusive. Morck et al. (1988), McConnell and Servaes (1990) and Short and Keasy (1999) treat stock option compensation as an exogenous phenomenon. In their respective research they assume stock option compensation does not depend on firm and environment characteristics and do not control for such characteristics. Conversely, a vast body of research does find certain firm and environment characteristics predict stock option compensation (Bryan et al. 2000; Gaver and Gaver, 2003; Khan et al. 2005; Firth et al. 2007; Wu and Tu, 2007; Berk and DeMarzo, 2011; Chen and Ma, 2011). Various investigations associate stock market return, firm size, R/D spending, corporate payout policy, capital structure, (institutional) ownership dispersion and leverage with stock option compensation. However, the level and composition of characteristics and their influence on stock option compensation varies in the previous literature. Even the direction of the relationship between certain firm characteristics and stock option composition differs between studies. Furthermore, the relationship between firm characteristics and stock option compensation was not investigated against the background of the 2008 global financial crisis.

The main rationale underlying the use of stock option compensation is mitigation of agency problems between the managers and owners of a firm. Theoretically, larger agency problems should lead to a bigger need for mitigation and thus stock option compensation. A number of firm characteristics is associated with agency problems. Therefore, I think the exogeneity assumption of a number of authors (Morck et al. 1988; McConnell and Servaes, 1990; Short and Keasy, 1999) is problematic. The firm characteristics mostly associated with agency problems are size, industry type and capital structure. Previous studies have either not investigated the effect of these characteristics on stock option compensation or found inconclusive results. In addition, the effect of firm characteristics on stock option compensation was not investigated in the context of the global financial crisis.

Cui and Mak (2002) investigated the relationship between stock option compensation and firm performance specifically in high R&D firms. They found a W-shaped relationship when using Tobin’s Q as performance measure. This effect differs from effects found in previous research where no or different controls where used when measuring stock option compensation. The different results obtained in different research might be due to the wrong assumption of exogeneity. Hypothetically, stock option compensation depends on a number of firm characteristics associated with agency problems. The results obtained by Cui and Mak (2002) illustrate the importance of industry effects. Furthermore size and capital structure (most importantly the level of debt) are associated with

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agency problems. This theory forms the basis for hypothesis 1. The hypothesized relationships are depicted in figure 1.

H1a: Capital structure (the level of debt) is positively associated with stock option compensation. H1b: Firm size is positively associated with stock option compensation.

H1c: Industry type significantly predicts stock option compensation.

H1a H1b H1c

Figure 1 Hypotheses 1a,b,c.

Stock Option Compensation and Firm Performance

The relationship between equity based compensation and firm performance is extensively investigated but results remain inconclusive. The rationale underlying stock option compensation is that it aligns managers and owners interests. Following this argument stock option compensation should enhance firm performance since firm performance is in the best interest of shareholders. Mehran (1995), Ittner et al. (2003), Richardson and Waegelein (2002) and Florackis et al. (2009) find a positive relationship between stock option compensation and firm performance. Conversely, Himmelberg (1999) and Palia (2001) find no clear relationship between firm performance and stock option compensation. Dong et al. (2010) argues that the natural risk aversion of managers hurts firm performance. Therefore stock options can be issued to induce risk taking. Chen and Ma (2011) and Dong et al. (2010) find positive relationships between stock option compensation and managerial risk taking while Capenter (2002) and Ittner et al. (2003) find no such relationship. In addition, Dong et al. (2010) finds that stock option compensation can increase the level of risk taking beyond a level desirable for shareholders. When this is the case stock option compensation starts hurting firm performance. This is in line with McConnell and Servaes (1990), who find an inverted U-shaped relationship between firm performance and stock option compensation.

Capital structure Firm size Industry type Stock option compensation

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This research focuses on the relationship between firm performance and stock option compensation. Stock option compensation is supposed to provide executives with incentives to act in the shareholders best interest. This relationship has been the subject of a vast body of research but results remain inconclusive. I hypothesize a positive relationship between stock option compensation and that the inconclusive results are due to different performance measures, firm characteristics and environmental characteristics. The rationale behind this is as follows: stock options only pay off if stock prices increase, therefore the positive relationship between stock option compensation should be stronger for financial performance measures than for general performance measures. To test for this effect analysis are performed using Tobin’s Q (a financial performance measure) and ROA. Secondly, certain firm characteristics (firm size and industry type) are associated with agency problems and need to be controlled for. Thirdly, stock options induce managers to take on risk. This should lead to a positive result in an economic upturn and, in line with Dong’s et al. (2010) argument, a less positive or negative result in an economic downturn because managers might take on too much risk. To test for this effect measurements are performed pre- and post 2008. In spite of severe political and public scrutiny the relationship between stock option compensation and firm performance has not been investigated since the global financial crisis took effect.

Agency problems adversely affect firm performance. Shareholders try to limit agency problems and split the costs of monitoring by appointing a corporate board. In addition managerial agency problems can be mitigated through equity based compensation. Awarding managers stock options incentivizes them to act in the best interest of owners because call options act as a performance dependent bonus that is awarded when stock prices rise (Ittner et al. 2003; Florackis, 2009). This rationale underlies hypothesis 2. This hypothesis is depicted in figure 2.

H2: Executive stock option compensation is positively associated with firm performance.

H2

Figure 2 Hypothesis 2.

Stock Option Repricing

After a market downturn, if stock options are significantly underwater, corporate boards can decide to reprice stock options. Primarily by issuing new stock options at a lower exercise price. The new exercise price tends to be the markets stock price, because in this way incentives are restored (see also graph 1), when firm performance has declined for reasons outside of management control

Stock option compensation

Firm

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(Chance et al. 2000; Acharya et al. 2000; Corrado et al. 2001; Carter and Lynch, 2001; Murphy, 2002; Yang, 2002; Wu, 2009; Aboody et al. 2010). The relationship between firm performance and repricing in a down market was previously investigated by Saly (1994) and Dunford et al. (2008). Saly (1994) found that, after a market wide crash, firms with underwater stock options issue significantly more stock options. Furthermore, stock options grants increase in value and firms suffering the largest impact from the crash are most likely to renegotiate. In addition, Saly (1994) states that optimal compensation packages consist of a fixed salary and stock options.

Since 2008, compensation schemes in the United States have become under severe public and political scrutiny. Previous literature however finds that lower firm performance leads to repricing in the form of new stock option issuance. In addition, a positive relationship is found between repricing and incentives effects (Saly, 1994). I hypothesize that firms that are adversely affected by economic conditions tend to reprice outstanding stock options.

This hypothesis is in line with Aboody et al. (2010) who found an increase in operating income and cash flows subsequent to stock option repricings. Aboody et al. (2010) find this effect only for executive stock options and not for employee stock options.

H3: Repricing is negatively associated with firm performance. H3

Firm Performance, Repricing and R&D intensity

Cui and Mak (2002) investigated the relationship between firm performance and stock option compensation in high R&D industries. R&D intensity is associated with an higher investment opportunity set and higher stock volatility (Himmelberg et al. 1999; Cui and Mak, 2002). Cui and Mak (2002) find that high R&D firms might rely more on ownership than on board governance to mitigate agency problems. Furthermore, they find the relationship between stock option compensation and firm performance to be W-shaped in high R&D industries. They point to the importance of industry effects. In addition, Chance and Kumar (2000) find that firms with bigger agency problems are more likely to reprice.

According to the literature, firms with bigger agency problems are more likely to reprice. R&D intensity is associated with bigger agency problems. In addition, R&D intensive firms are more prone

Firm

Performance

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to stock volatility which theoretically would lead them to be more affected by an economic downturn such as that of 2008. Therefore, I hypothesize that R&D intensity moderates the negative association between firm performance and stock option repricings.

This hypothesis is in line with Saly (1994), Chance and Kumar (2000) and Aboody et al. (2010) who found significant negative associations between firm performance and repricing. In addition, they found this effect to be stronger for firms with bigger agency problems, larger investment opportunity sets and higher stock volatility, all characteristics that apply to R&D intensive firms.

H4: The relationship between firm performance and repricing (H3) is moderated by R/D intensity.

H4

2.3 Conceptual Framework

The previous section summarized the core research gaps and hypotheses stemming from them (figure 1,2,3,4). The 2008 global financial crisis caused severe scrutiny from regulators and a highly adverse public opinion on equity based compensation, income inequality, bonuses, risk taking, corporate governance in general and a variety of other issues in the United States. However, the literature on equity based compensation in general and stock option compensation specifically is inconclusive with regard to the desirability of performance related pay. According to some literature stock option compensation positively relates to firm performance whereas other authors find no or even a negative relationship. Especially interesting is that one of the core arguments in favor of stock option compensation is inducing risk taking by managers. However, some authors argue that it can lead to excessive risk taking (Dong et al. 2010), which can lead to short-terminism which is one of the core criticisms of equity based compensation in the wake of the financial meltdown. This thesis revisits the debate on stock option compensation against the background of the 2008 crisis. Stock option compensation, its predictors and its effect on firm performance are the core variables. In

Firm

performance

R/D intensity

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addition, given the rapid market deterioration in 2008, repricing is investigated. Figure 5 depicts a conceptual framework in which the hypotheses are summarized.

H1a

H2 H3 H1b

H1c H4

Figure 5 Conceptual framework.

H1a: Capital structure significantly predicts stock option compensation. H1b: Firm size significantly predicts stock option compensation.

H1c: Industry type significantly predicts stock option compensation.

H2: Executive stock option compensation significantly affects firm performance. H3: Firm performance and repricing are significantly related.

H4: The relationship between firm performance and repricing is moderated by R/D intensity. Capital Structure R/D Intensity Repricing Firm Performance Stock Option Compensation Type of Industry Firm Size

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3 Methods

This section will describe the methods used to test the different hypotheses. The first section describes the sample and data collection. The second section introduces the core variables and the proxies used to test them. The third section describes the control variables and the fourth section introduces the regression analysis used.

3.1 Sample and Data Collection

The sample will consist of industrial U.S. S&P 500 firms in the years 2005-2007 and 2009-2011, a list of all the firms incorporated in this research can be found in appendix B. The sample is chosen in this way to compare data from before the 2008 global financial crisis, with data in the years directly after the crisis. The use of S&P 500 firms ensures a sufficient sample size and, in addition, the use of industry leaders furthers the availability of performance and compensation data.

Data was retrieved from three different databases. In order to proxy firm performance, data on ROA and Tobin’s Q were retrieved from Datastream. Balance sheet items such as total revenue, R/D expenditure, long-term debt and shareholder’s equity as well as descriptives such as industry type (GIC sector), fiscal year and company name were retrieved from Compustat. Execucomp was used to retrieve data on executive compensation such as total compensation, grant date option value and total options issued.

The final sample includes all firms that reported on stock option compensation and excludes financial firms. Since U.S. firms are only required to report data on stock option compensation since November 2006 (SEC, 2006), the sample is slightly smaller for 2005 and 2006. The final sample includes 1937 observations from 444 firms over 6 years. In order to investigate the moderating relationship of research and development, for hypothesis 4, the sample was reduced to all non-financial firms that reported on R/D expenditure (1154 observations). Reporting on R/D expenditure is not obligated under SEC regulation so not every company provides this statistic (SEC, 2006).

3.2 Core Variables

Stock Option Compensation

The independent variable under investigation in hypotheses 2 and the dependent variable in hypothesis 1 is the use of stock option compensation. Since great variation exists in the number of options awarded and their value to total compensation the use of stock options will be measured using the incentive ratio (Chen and Ma, 2011). This ratio, given in equation 1, measures the incentive effect of stock options in a particular case by dividing the aggregate Black-Scholes option value through the total compensation value. The Black-Scholes formula is explained in more detail in 7. In

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practice, the aggregate value of grant date stock options retrieved from Execucomp was used. In 2005 and 2006 this was estimated using the Black-Scholes value, for years after 2006 the value provided by companies was used. Since 2006, the SEC requires companies to provide such a statistic but companies are free to choose the method of calculation. Companies, in almost all cases, use Black-Scholes to calculate this value but there might be some companies in the sample that used another method.

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Firm Performance

The dependent variable in hypothesis 2 and the independent variable in hypothesis 3 and 4 is firm performance. Firm performance will be measured using both Tobin`s q and return on assets. Return on assets, given in equation 2, indicates the net income per dollar of assets employed and is a common measure of firm performance.

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To measure firms financial performance Tobin`s q, given in equation 3, will be used. Tobin`s q is especially interesting in light of the relationship under investigation here, because it measures the market (and thus shareholder) value of a company to the assets it employs (Cui and Mak, 2002). The higher the outcome of Tobin`s q, the better a firm performs in the market. A value below 1 indicates that assets cost more than the profits they generate. A value above 1 indicates that a firm is overvalued in the market.

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Cui and Mak (2002), in their investigation of equity compensation in high R/D firms find very different results for ROA and Tobin’s Q (both measures of firm performance are even negatively correlated in their study). Therefore, in this thesis, I chose to run regressions on both performance variables. It could, for example, be possible that Tobin’s Q is influenced more by stock option compensation because the price of underlying shares is tight more directly to financial performance than to ROA. Furthermore, ROA can differ significantly across industries.

Repricing

The dependent variable under investigation in hypotheses 3 and 4 is repricing. Given that repricing since 2000 always involves the issuance of new stock options (Yang, 2011), this variable can be

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measured using the issuance of stock options. To measure repricing activity, the total number of new stock issued in a year will be measured.

R/D intensity

R/D intensity is the moderator variable in hypothesis 4. A common proxy for R/D intensity is R/D expenditure. In this thesis R/D intensity is measured using the ratio of R/D expenditure to total revenue (formula 4).

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Capital Structure

Capital structure is the independent variable in hypothesis 1a. It refers to the combination of debt and equity a corporation uses to finance its assets (Berk and DeMarzo, 2011). Capital structure, in previous literature, was found to have an effect on both agency problems and equity based compensation. Capital structure is defined as the debt to equity ratio (formula 5).

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Firm Size

The independent variable in hypothesis 1b is firm size. Larger firms are associated with bigger agency problems. Hypothetically, this leads to a bigger need for mitigation and thus more stock option compensation. Firm size will be measured using firms total revenue.

Industry

Cui and Mak (2002), found that stock option compensation is not exogenous and depends on firm specific characteristics. The independent variable in hypothesis 1c is industry type. To measure the effect firm specific characteristics in different industries have on stock option compensation, firm types will be included as a dummy variable using Standard and Poor’s Global Industry Standard Classification. The GISC classifies firms into ten industries: energy, materials, industrials, consumer discretionary, consumer staples, healthcare, financials, information technology, telecommunication services and utilities. This measurement will be included as a dummy variable in which a company is coded as 1 if it belongs to an industry and as 0 if it does not belong to an industry. Financials are excluded from the sample.

Stock option compensation revisited : the effect of stock option compensation on firm performance in times of crisis