Executive Pay, Innovation, and Risk-Taking

43 Pages Posted: 15 Jan 2010 Last revised: 29 Jul 2014

Volker Laux

University of Texas at Austin - McCombs School of Business

Multiple version iconThere are 3 versions of this paper

Date Written: October 16, 2012

Abstract

This paper analyzes the optimal executive pay arrangement in a setting in which the CEO must be motivated to search for innovative investment ideas and, if he uncovers one, to implement the idea if and only if it is not excessively risky. I show that, depending on the value of the firm's potential growth opportunities and the CEO's concern about being fired, the CEO is either tempted to overinvest in risky ideas (excessive risk-taking) or underinvest in risky ideas (excessive conservatism). The optimal pay package consists of stock options, to encourage the discovery of innovative ideas, and either restricted stock, to combat excessive risk-taking, or severance pay, to combat excessive conservatism. The model provides new empirical predictions regarding the determinants of executive compensation arrangements and analyzes how the change in the economic environment caused by the current financial crisis might change the optimal mix of stock options, restricted stock, and severance pay.

Keywords: Executive Pay, Stock Options, Restricted Stock, Severance Pay

JEL Classification: J33, G24

Suggested Citation

Laux, Volker, Executive Pay, Innovation, and Risk-Taking (October 16, 2012). Available at SSRN: https://ssrn.com/abstract=1536106 or http://dx.doi.org/10.2139/ssrn.1536106

Volker Laux (Contact Author)

University of Texas at Austin - McCombs School of Business ( email )

Austin, TX 78712
United States

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