The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options

Financial Management, Vol. 30, Iss. 2, Summer 2001

Posted: 8 Aug 2001

See all articles by Lisa K. Meulbroek

Lisa K. Meulbroek

Claremont McKenna College - Robert Day School of Economics and Finance

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Abstract

To properly align incentives using equity-linked compensation, the firm's managers must be exposed to firm-specific risks, but this forced concentrated exposure prevents the manager from optimal portfolio diversification. Because undiversified managers are exposed to the firm's total risk, but rewarded (through expected returns) for only the systematic portion of that risk, managers will value stock or option-based compensation at less than its market value. This paper derives a method to measure this deadweight cost, which empirically can be quite large: managers at the average NYSE firm who have their entire wealth invested in the firm value their options at 70% of their market value, while undiversified managers at rapidly growing, entrepreneurially-based firms, such as Internet-based firms, value their option-based compensation at only 53% of its cost to the firm. These estimates prompt questions of whether compensation plans in such firms are weighted too heavily towards incentive-alignment to be cost effective.

Suggested Citation

Meulbroek, Lisa K., The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of Awarding Executive Stock Options. Financial Management, Vol. 30, Iss. 2, Summer 2001. Available at SSRN: https://ssrn.com/abstract=275533

Lisa K. Meulbroek (Contact Author)

Claremont McKenna College - Robert Day School of Economics and Finance ( email )

500 E. Ninth St.
Claremont, CA 91711-6420
United States
909-607-7363 (Phone)

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