The Value of Performance Signals Under Limited Liability
72 Pages Posted: 29 Aug 2014 Last revised: 14 Jun 2019
Date Written: May 15, 2019
This paper studies the value of additional performance signals under limited liability. We show that -- contrary to the informativeness principle -- informative signals may have no value, because the payment cannot be adjusted to reflect the signal realization. We derive new conditions for a signal to have value under limited liability, and study how valuable signals should be incorporated into the contract. In a compensation setting, we show precisely how the signal realization should change the number of vesting options and the option strike price, providing guidance for performance-based vesting. Surprisingly, it may be optimal for more options to vest upon a negative signal of effort. In a financing setting, our results also have implications for whether the debt repayment should be performance sensitive.
Keywords: informativeness principle, limited liability, option repricing, pay-for-luck, performance-based vesting, performance-sensitive debt
JEL Classification: D86, G32, G34, J33
Suggested Citation: Suggested Citation