Introduction

This analysis of share-based compensation history in Finland offers two kinds of perspectives regarding the adoption of executive stock option (ESO) plans and broadening of the scope of share-based compensation. These two perspectives have different origins from 1) the academic literature with its theoretical emphasis on agency theory (AT) and managerial power theory (MPT) and 2) the perspective of practice with an emphasis on institutional and contextual changes and discussions from inside the board room.

Much of the development of executive compensation follows a more general phenomenon in Europe identified by Baeten and De Ruyck (2020).

This study of the history of share-based compensation in Finland provides several lessons for practitioners that apply to other countries. Among those lessons we will be discussing in this paper are very concrete and essential guidance for executive compensation professionals and board members, especially compensation committee members.

Guidelines for Designing Share-Based Incentive Plans

Good corporate governance is essential. High-quality corporate governance helps mitigate the danger of overpayment of top management remuneration at the expense of shareholders.
The definition of key metrics is the most important aspect in long-term incentive (LTI) plan design. What does the board want to pay for and what kind of message/order does it want to send to top management for the next three to five years? If board members are happy with total shareholder return (TSR), they should be happy to pay for it. If the board members expect profitable growth, they should be happy to pay for it no matter what the company’s TSR has been during the period.
Company strategy should inform the establishment of performance criteria. The compensation plan, or at least part of it, should be based on that strategy. If environmental, social and governance IESG) is not in the company’s strategy, why should it be one of the few criteria for long-term incentives (LTIs)? Is it just “greenwashing” (falsely positioning a company as environmentally friendly rather than actually minimizing its environmental impact)?
The board should understand the role of LTIs as a part of the overall remuneration, the target total compensation. First, understand what the remuneration policy is: Is it a proportion of fixed and flexible elements, and in the flexible part, what is the size of the short-term incentives (STIs) vs. the LTIs? Second, understand the valuation of the total compensation, especially its most complicated part, the LTIs, and the theoretical annualized value of the LTIs. Third, understand and decide on the value and structure of each executive team member, with the CEO being the most important individual, of course.
The compensation package, including the LTIs and annual fair value, should be communicated individually to each executive team member. Their understanding of their own total salary is typically worse than a bus driver´s because understanding fair annual value (best guess of future payout) of a share-based LTI will remain unclear if it is not communicated. Only the CFO should be able to understand that without help.

Lessons Learned from Finland’s History of Share-Based Compensation

This paper will discuss:

The adoption of share-based compensation coincided with the time of financial market liberalization. Executive stock options (ESOs) as a component of executive compensation were copied from the United States to attract foreign capital and to align executives’ interests with shareholders’ interests.
ESOs were early-phase solutions for the agency problem between owners and executives. But they also allowed executives to set their own compensation because boards of directors did not take a leadership role for the design process. Board members and executives showed both a lack of interest and a lack of competence.
The burst of the dot-com bubble precipitated a shift away from ESOs to the use of the more versatile share-based systems. A need emerged after the dot-com bubble burst in the early 2000s for share-based compensation systems, which better connect managerial and shareholder interests irrespective of stock market conditions. Companies adopted performance-based shares, where a performance component aligned managerial short-term goals and activities with the long-term perspective of owners.
The public outcry over excessive executive compensation in the early 2000s led to increased transparency of share-based compensation when the International Financial Reporting Standard on share-based payments (IFRS 2) and, later, say-on-pay legislative measures were adopted. These legislative changes increased the awareness of share-based systems’ costs and allowed shareholders to express their opinions.
The development of corporate governance in the early 2000s took major steps to organize board work with clear responsibilities and processes for designing executive compensation. Compensation committees were introduced to lead the executive compensation design process. Foreign board members played an important role by bringing in their experience in executive compensation design.
Share-based systems have become a fundamental component of Finnish executive compensation in publicly listed companies as a result of increased transparency, shareholder voices and advancements in board work. The compensation structure has become more performance-based, and compensation levels have only moderately increased.
A major lesson from our Finnish case is that if you want to design a high-quality, share-based system, you must have high-quality transparency and high-quality design processes. Otherwise, you may end up with inappropriate share-based systems with unintentional excessive compensation, reputation loss and bad company performance.

The History and Development of Share-Based Systems in the Finnish Economy

Finland, with a population of about 5.6 million, is a rather wealthy developed economy in the Euro Zone with a GNP of $54,890 per inhabitant, which is slightly above the average for European Union nations. It has been named the world's happiest country for seven years in a row by the UN World Happiness Report.

In the early 1990s, Finland transitioned from a credit-based to a capital-market-based ﬁnancial system. It adheres to the Scandinavian legal tradition, in which there is a very high level of protection for minority shareholders (Djankov et al. 2008).

Finnish-listed companies have a high ownership concentration, with various types of block holders, ranging from families and the state of Finland to pension funds and investment companies. Foreign investor ownership in the Finnish stock market is great but dispersed. Most foreign investors are portfolio investors who are not interested in becoming block holders of a listed company (Jakobsson and Korkeamäki 2015).

According to the Finnish Limited Liability Companies Act, the board of directors has power over the executive management. Finnish-listed companies have adopted the one-tier system, in which employees have no legal right to have representatives on the board. The Finnish Limited Liability Companies Act also allows different classes of shares with different voting power rights (Jakobsson and Korkeamäki 2015).

The boards of directors in Finnish companies have the ofﬁcial responsibility and power to decide on executive remuneration, with one exception: stock-based remuneration systems if new equity is issued. A shareholder meeting is required to make decisions in this case.

Alternatively, the shareholder meeting may authorize the board of directors, within certain limits, to issue new shares for equity remuneration systems as well. Publicly listed companies have established a remuneration policy that is submitted to an advisory vote by shareholders at a minimum of every four years, following the adoption of the Shareholders’ Rights Directive in 2019.

Increased Foreign Ownership and the Adoption of ESOs

The evolution of ESOs followed the development of local stock market regulation and liberalization. In 1984, 20% foreign ownership was allowed in publicly listed firms and an Over the Counter (OTC) list of small companies was introduced. Additionally, the first Securities Market Act was amended in 1989.

A strong stock market boom occurred in the late 1980s as a consequence of financial market deregulation (Vaihekoski 1997). The introduction of the first ESOs in 1987 was due to these developments in the stock market and the emergence and increased role of foreign ownership. The very first phase of ESO adoption stopped in the early 1990s because stocks listed on the Finnish stock market lost almost 75% of their value. ESOs lost their value and the role of incentivizing executives when share prices drastically decreased.

The next liberalization phase of the financial markets pushed the development of ESOs into a new phase. Foreign ownership was fully liberalized as Finland became a member of the European Economy Area in 1993 (Ylä-Anttila et al. 2005). Foreign ownership of publicly listed Finnish companies rose very quickly.

Foreign ownership was below 10% of market value in Finnish-listed companies in the early 1990s, increasing to 65% in 2000. Foreign ownership represented about 40% of market value in 2013 (Jakobsson and Korkeamäki 2014).

The most important group of foreign owners comprised the U.S.-based mutual and pension funds that were familiar with the U.S.-UK corporate governance practices with their close alignment between the shareholders’ and executives’ interests with ESOs (Ylä-Anttila et al. 2005), which has been a frequently used instrument for executive pay in the U.S. since the 1980s (Hall 1998; Frydman and Saks 2010).

Publicly listed Finnish companies adopted ESOs to meet the U.S.-UK corporate governance system with its compensation practices that emphasized return on capital and equity more than did the traditional Nordic system ( Ylä-Anttila et al. 2005).

Figure 1 illustrates the development of ESOs from 1987 through 2002. Publicly listed Finnish companies almost solely issued ESOs during this period. Their popularity became more common first in 1989 and then from the period after foreign owner liberalization and especially since 1997. From 1997-2002, most publicly listed Finnish companies adopted ESOs.

Foreigners started to become board members of the largest listed Finnish companies. And, many boards’ language changed from Finnish to English.

These new foreign and distant owners were interested in ensuring that companies and their executives properly considered their interests as shareholders. Finnish companies were also interested in attracting new foreign owners, and ESOs were one way to do that. A similar change in executive compensation systems occurred globally in the 1990s, including Europe (Murphy 1999).

By the 2000s, foreigners had started to become board members of the largest listed companies. Company ownership and operations had become international. Many boards’ language changed from Finnish to English.

ESOs Extended to More Employees

The preceding discussion shows that ESOs were perceived to be a suitable instrument for executive compensation to mitigate agency problems. The institutional U.S. investors were interested in ensuring that their interests as distant shareholders were properly considered. The early phase of ESO adoption supported agency theory (AT). Interestingly, we do not find any clear indications of managerial power theory (MPT).

ESOs were initially targeted to top executives, but the number of grantees radically increased very soon as companies began extending the target audience more broadly — first to middle-level managers and even to all employees in some companies.

The ESOs targeted for wider employee groups gradually became common from 1998 onward. Almost half of the ESOs were targeted to wider employee groups in 2000. The number of grantees increased from 81 individuals in 1997 to more than 21,000 in 2000, peaking in 2002 with over 24,000 grantees. However, the number of grantees was drastically reduced in 2004 to only 2,880 (Keloharju and Lehtinen 2018).

On the one hand, the use of ESOs for employees provides an indication of equality in Finland. On the other hand, broad-based ESOs were used in companies that were human capital-intensive and where monitoring employee performance was hard to implement (Jones, Kalmi, and Mäkinen 2006). Their findings and conclusions also support AT-based monitoring argumentation, where agency problems were of different types in the case of broad-based ESOs, as in the case of ESOs, targeted to top management.

The Dot-com Bubble Bursts and More Share-Based Systems Are Adopted

The stock market prices of many information and communications technology (ICT) companies reached an all-time high at the turn of the millennium prior to the dot-com bubble burst in early 2000. The ESOs of these companies generated considerable compensation for executives and also for other employees in many companies.

The highest sums of ESOs for individual executives in the best year were worth around 10 million Euros (before taxes, but the tax bracket was more than 50%). The top management's remunerations provoked criticism in several companies, even though their ESO-based compensation was due to a considerable increase in the share value.

After the dot-com bubble burst, a new era of share-based compensation emerged with a more nuanced and broader variety of share-based systems. Figure 2 shows both the proportion of companies having share-based compensation in general and what kind of share-based compensation in more detail.

Performance-based shares were first adopted in 1999, but they became more common after 2004. Performance-based shares also seem to be the most common share-based compensation system elsewhere in Europe, with the exception of Belgium (Baeten and De Ruyck 2020).

Share plans that require the executives’ own investment as well as restricted stocks have also become more common.

The change in this millennium has been dramatic. Publicly listed Finnish companies had, on average, 1.05 share-based systems, which typically were ESOs, in 2000. In 2010, 1.53 systems were used, on average, and the average is more than two since 2014. The most common systems are performance shares, restricted shares and direct share ownership.

Interestingly, the proportion of Finnish companies that have some kind of share-based system has hovered around 75%, a percentage that has been very stable over time. The use of ESOs as a compensation system has decreased: 98% of companies having a share-based system had ESOs in 2000, whereas only 15% of companies with a share-based system had ESOs in 2022. The change is similar in other parts of Europe and the United States, so the explanations of this change have broad relevance.

To conclude, only ESOs were used in the early stage of share-based systems, but with the dot-com bubble burst, other share-based compensation systems complemented and also replaced ESOs. There are no indications of them being abandoned. We offer an analysis of these developments in the next section.

Improving the Quality of the Remuneration Decision Process

In the 1980s, the boards of Finnish publicly listed companies handled issues related to management remuneration very lightly. Rewards matters were very simple. What was to be decided was a fixed salary, additional pension benefits and an annual performance bonus system in which the bonus opportunity was defined as a certain share of the fixed annual salary.

The CEOs of listed companies had to be proactive in introducing long-term incentive systems tied to shareholder value. CEOs also had a major role in introducing their own compensation and ESOs for boards of directors in the early phase of share-based compensation. There were no foreign members on the boards, and the CEOs had no experience working in management positions in foreign companies.

Neither the boards nor the CEOs had information about these systems. The boards had not established remuneration committees. Presentations and proposals about ESO programs were discussed by the entire board. The discussion was usually about the dilution effect and the personal earning potential of senior executives.

It was rather easy for the consultants to sell ESOs to both executives and board members because the principal idea of the relationship between share price and ESO value is very simple: As share price increases by one Euro, the value of an ESO increases by one Euro, and depending on the number of ESOs an executive owns, the executive knows the total value increase of the ESO ownership.

From the perspective of practice, there were clear elements of managerial power theory (MPT) when ESOs were being introduced, because the process of defining executive compensation was in the hands of the executives themselves. However, there were also clear indications of combining the interests of executives with those of the shareholders, also supporting the agency theory (AT) perspective.

The consultancy industry has played an important role in introducing share-based compensation systems. The consultancy markets for share-based systems were already highly concentrated from the beginning, with one consultant, currently known as Allshares Oy, almost fully dominating the markets. The company’s partners were actively promoting share-based incentives as a compensation system to align executives’ and shareholders’ interests, thus accelerating the market’s development. Compared to the United States, with three major companies having more than 60%, and the UK market, with two companies with more than 55% market share (Conyon, Peck and Sadler 2009), the Finnish executive compensation consultancy markets were exceptionally concentrated.

Analysis of Moving from ESOs to Other Shared-Based Compensation

Next, we analyze the time period when the use of ESOs was reduced and other types of share-based compensation implemented. There are several plausible explanations: public disapproval; academic research results; the practical experiences of using ESOs; and changes in institutional settings, such as in financial reporting regulations, compensation reports and shareholders’ say-on-pay executive compensation.

Public Disapproval of ESOs

ESOs aligned the interests of stockholders and executives — if stockholders gained a lot, so did executives. There were several success stories in the 1990s, including Raisio Group in the food industry, Nokia with its mobile phones, and Hartwall in the soft-drink industry. Exceptional stock returns resulted in an exceptional level of executive compensation in all of these cases. Such a level of compensation was never experienced before in Finland, sowing doubts about managerial self-interest.

The final tipping point for public discussion on managerial remuneration occurred in early 2000 as executives of Fortum, a mainly state-owned energy company, gained exceptional executive compensation levels due to a very strong increase in its share price. For politicians whose ministries were responsible for state-owned enterprises (SOEs), such compensation levels appeared to be very problematic, resulting in great political pressure to eliminate such compensation levels. As a result of this critical discussion on executive compensation, and especially ESOs, the Finland decided to ban the use of ESOs as a compensation system in 2004 (Pekkarinen 2004).

Publicly listed SOEs consequently changed their compensation practices from ESOs to other share-based compensation systems. Finland’s 2004 decision is still in effect.

Even though the alignment between the stockholders and executives’ interests in ESOs is clear, the public disapproval clearly indicates that, at least politically and in the public press, managerial power theory (MPT) is supported, Executives gained too much as share prices multiplied. Executives with exceptionally high compensation were found to be as guilty as the compensation instrument ESO itself.

The Introduction of IFRS 2

Share-based systems became more transparent in 2005 as the International Financial Reporting Standard on Share-based Payment (IFRS 2) came into force. According to IFRS 2, the cost of share-based payments should be expensed in income statements. A similar standard (FAS 123r) came into force in the United States in 2006.

The value of share-based systems should be estimated in order to expense them, giving many managerial considerations both in ESOs and performance-based shares.

Before these standards, the costs of share-based systems were reported only in footnotes. These standards emphasized the costs of share-based systems to shareholders. Prior to those standards, it was contended that share-based systems were not transparent enough, resulting in the risk of excessive executive compensation so that the decision makers, (i.e., the shareholders and boards of directors) were not fully aware of these systems’ value. This was true even for executives.

The value of share-based systems should be estimated in order to expense them, giving many managerial considerations both in ESOs and performance-based shares. We may expect that executives would be interested in downplaying the value of share-based systems, but the results of prior studies do not support this expectation. On the contrary, the empirical evidence even indicates that companies value them higher than their theoretical values (Edmans, Gabaix, and Jenter 2017).

The decrease in the use of ESOs interestingly coincides very closely with the time when IFRS 2 came into force. According to Bebchuk and Fried (2003), less transparent executive compensation practices were used to camouflage the amount of total compensation. Decision makers became more aware of ESOs’ costs and were reluctant to use them for incentive purposes as IFRS 2 was implemented. This decrease in the use of ESOs at the time of increased transparency of their costs provides evidence supporting the MPT approach.

Remuneration Reports and Say-on-Pay

The amending directive on the exercise of certain shareholder rights in listed companies in 2017 empowered shareholders to vote on executive compensation. This directive allows shareholders to vote, or exercise say-on-pay, for executive compensation based on a remuneration report at an annual meeting. This non-binding voting allows Finnish shareholders to express their opinions on the remuneration policy and on realized executive compensation.

Similar say-on-pay practices have been in use for a longer time in the U.S., Canada and the UK.

The results of academic research (in the U.S., Balsam, Boone and Yin 2016, and Kimbro and Xu 2016; in the UK, Ferri and Maber 2013) indicate that shareholders’ voices have reduced excessive compensation and increased the proportion of share-based systems. The pay level has also slightly increased because of an increased risk level in executive compensation.

Corporate Governance to a New Level at the Turn of the Millenium

Corporate governance began to develop in rewards matters with the experiences gained from ESO programs in the late 1990s. A Corporate Governance Code of publicly listed companies was issued for the first time in 1997. It was jointly published by the Central Chamber of Commerce and the Union of Industries and Employers. The Finnish government, as a significant owner of listed companies, also issued its guidelines in 1998 on rewarding the executives of companies under its influence.

Owner control regarding compensation matters developed strongly after the dot-com bubble burst. Remuneration committees were established on the boards of larger companies. The committees' task was mainly to prepare the remuneration systems and other decisions regarding executive remuneration.

Committee chairs, instead of CEOs or HR managers, started hiring consultants and working with them on incentive preparation. The CEO and HR director participated in the preparation of the incentive, but the process was led by the chairman of the board or by the whole remuneration committee. The Corporate Governance Code of publicly listed companies in 2003 recommended establishing a compensation committee.

The boards gained more remuneration knowledge and experience through all of this. The boards began to understand the concept of target total compensation and knew how to demand the measurement of share-based compensation as part of the total compensation. The introduction of the IFRS standard also encouraged the understanding of share-based compensation as an expense for the company and not just as dilution for the owner.

From the perspective of theory, most of the discussions in the board room focused on the learning and development of executive compensation to align the executives’ interests with shareholders’ interests, especially in the case of foreign owners and board members supporting the AT perspective. However, some issues, such as increased transparency, indicate that there were concerns about MPT.

The increased importance of a compensation committee and improved transparency also indicate that the opportunities for managerial influence become smaller, thus reducing the danger of managerial entrenchment and focusing more on aligning executives’ interests with shareholders’ interests, supporting the AT perspective.

The Development of Academic Knowledge

ESOs and other share-based systems have been under extensive interest in academic research in the U.S. and the UK. In this section, we discuss why share-based systems in general would be beneficial for certain types of companies, and what features of ESOs have influenced their decreased popularity among listed companies. .

The use of share-based systems is most beneficial for companies that operate in an uncertain environment and for larger companies. It is highly difficult to monitor managerial activities in companies operating in uncertain environments. Thus, instead of monitoring, aligning interests is more beneficial. This conclusion is supported by both theoretical models and empirical evidence (Edmans, Gabaix, and Jenter 2017).

Share-based systems are also beneficial for large companies. Agency problems and monetary consequences are both more severe in large businesses. Large companies also have more capacity to hire the best executives. Empirical studies indicate that both monetary value and the proportion of share-based systems are larger in large companies. The shares’ trading volume on the stock exchange is larger in large-cap companies, and the price can be anticipated to better reflect the operative performance and future prospects.

If share-based compensation systems are beneficial, which are better: ESOs or shares? The answer is clear if we analyze how executives value the incentives offered.

ESOs are inefficient for risk-averse executives because relative to the economic sacrifice of diversified owners, the value of ESOs is only about 40% to 60% of its value (Hall and Murphy 2002). Other share-based systems are much more efficient (Edmans, Gabaix, and Jenter 2017).

The reason for this difference lies in the higher risk level of ESOs relative to other share-based systems. Only in the case when owners want to encourage executives to take more risks would the use of ESOs be a suitable element of executive compensation.

ESOs are noisy incentive systems because they also reward or punish executives for random (un)favorable events in the business environment that are out of the executives’ control.

The danger of excessive managerial risk-taking would naturally result in bad high-risk investments that could destroy company value.

ESOs are noisy incentive systems, because they also reward or punish executives for random (un)favorable events in the business environment that are out of the executives’ control. Therefore, performance-based shares are preferred over ESOs because they more directly connect executives’ activities to their rewards in the short term.

Performance-based shares combine the accuracy of measurement and executive influence with the longer time horizon of the share-based system. Companies with a fast-growing business, where the quality of accounting measurement is lower, favor restricted shares instead of performance-based shares (Edmans, Gabaix, and Jenter 2017).

ESOs lost their value in stock market downturns, simultaneously losing their role to incentivize and engage executives. For these purposes, performance-based shares and other share-based systems fit better with a lower level of risk and a close alignment with executive work and compensation. Performance-based shares are the appropriate instrument for communicating strategic direction to support long-term value creation.

Discussion and Conclusions

We learn several lessons from the history of share-based compensations in Finland. The first adoption of share-based compensation was in a form of executive stock options (ESOs). They were introduced to Finnish-listed companies when the financial markets were liberalized.

ESOs were adopted directly from abroad as a major means of aligning executives’ interests with shareholders’ interests. This was a common practice in the U.S., and this was perceived as an appropriate solution for the alignment.

From the outside perspective, the introduction of ESOs is perceived as a solution to agency problems. For the foreign investors, it was a proper indication of a shareholder perspective among executives. From the inside perspective, this first phase of learning allowed executives to define their own compensation without any proper role for a board of directors. Both board members and executives were learning to use them. We perceive elements that clearly support the managerial power theory (MPT).

The dot-com bubble burst and the public outcry influenced a major change in the share-based systems. First, the burst of the bubble led to the perception that ESOs were not serving their original purpose of motivating and committing executives. Companies adopted performance-based shares instead of ESOs, so that a performance component was combined with managerial short-term goals and activities and the ownership of shares with a long-term perspective. Second, the public outcry led to increased transparency of share-based compensation and the development of corporate governance simultaneously took major steps for organizing board work in the compensation committees.

The compensation structure become more performance-based and compensation levels increased only moderately., and the preventive measures indicate that the agency theory (AT) perspective was underlined both in soft laws, such as corporate governance codes, and in hard laws, such as IFRS 2 and say-on-pay regulation. The processes and structures of executive compensation developed into a more professional and independent direction, limiting the room for managerial opportunism and underlining the role of the AT perspective.

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