Stock-Based Pay: An Incentive for Performance or a Compensation for Competence? How to Compensate a Manager When He is Competent?

Abstract

This article presents a model describing an optimal compensation contract for the manager. The model is based on an appropriate balance of power between the shareholder who holds the right to receive dividends and the right to dismiss the manager and the manager who holds the right to wages and a discretionary right to withdrawals. An optimal model is defined from three viewpoints: that of the shareholder, the manager and the economy. The model shows that an optimal contract depends on the competence of the manager and the following elements: threat of take-overs, severance costs, reputation costs. In all cases, dismissal acts as an efficient natural protection against unreasonable discretionary withdrawals. Stock-based pay must be viewed more as a method for wealth distribution between human capital and financial capital than as an incentive mechanism for performance.

Keywords: governance, compensation, manager, shareholder, real option, human capital

JEL Classification: C70, G32, G38