How Should Performance Signals Affect Contracts?

81 Pages Posted: 29 Aug 2014 Last revised: 18 Mar 2021

See all articles by Pierre Chaigneau

Pierre Chaigneau

Queen's University

Alex Edmans

London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Daniel Gottlieb

London School of Economics

Multiple version iconThere are 4 versions of this paper

Date Written: January 11, 2021

Abstract

The informativeness principle demonstrates that a contract should depend on informative signals. This paper studies how it should do so. Signals that indicate the output distribution has shifted to the left (e.g. weak industry performance) reduce the threshold for the manager to be paid; those that indicate output is a precise measure of effort (e.g. low volatility) decrease high thresholds and increase low thresholds. Surprisingly, “good” signals of performance need not reduce the threshold. Applying our model to performance-based vesting, we show that performance measures should affect the strike price rather than the number of vesting options, contrary to practice.

Keywords: informativeness principle, limited liability, option repricing, pay-for-luck, performance-based vesting, performance-sensitive debt

JEL Classification: D86, G32, G34, J33

Suggested Citation

Chaigneau, Pierre and Edmans, Alex and Gottlieb, Daniel, How Should Performance Signals Affect Contracts? (January 11, 2021). Review of Financial Studies, forthcoming, European Corporate Governance Institute (ECGI) - Finance Working Paper No. 439/2014, Available at SSRN: https://ssrn.com/abstract=2488144 or http://dx.doi.org/10.2139/ssrn.2488144

Pierre Chaigneau

Queen's University ( email )

Smith School of Business - Queen's University
143 Union Street
Kingston, Ontario K7L 3N6
Canada

Alex Edmans (Contact Author)

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Daniel Gottlieb

London School of Economics ( email )

New Academic Building 5.30
Houghton Street
London, WC2A 2AE
United Kingdom

HOME PAGE: http://https://personal.lse.ac.uk/gottlied/

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