An Analysis of Net-Outcome Contracting with Applications to Equity-Based Compensation

49 Pages Posted: 8 Aug 2017 Last revised: 23 Jul 2021

See all articles by Christian Hofmann

Christian Hofmann

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management)

Steven J. Huddart

Pennsylvania State University, University Park - Department of Accounting

Thomas Pfeiffer

University of Vienna - Accounting and Control

Date Written: July 19, 2021

Abstract

Options, restricted stock, bonuses tied to total shareholder return, and similar equity-based compensation contracts stipulate payments that depend on stock price. Any such contract is a function of shareholder value net of the compensation payment, because stock price (1) is proportional to this net value or “net outcome” and (2) anticipates compensation-related payments and dilution. The net outcome, in turn, is reduced by the payment and so depends on the contract. Standard moral hazard analyses, wherein contractual payments are based on the gross outcome before any payment to the agent, overlook this dependency. We characterize the optimal net-outcome contract, describe its shape and pay-for-performance sensitivity, contrast it to the optimal gross-outcome contract, and discuss implications for equity-based compensation arrangements.

Keywords: dilution, equity-based compensation, moral hazard, team compensation, optimal contracting, pay-for-performance sensitivity, security holdings, stock options

JEL Classification: D86, J33, M41

Suggested Citation

Hofmann, Christian and Huddart, Steven J. and Pfeiffer, Thomas, An Analysis of Net-Outcome Contracting with Applications to Equity-Based Compensation (July 19, 2021). Available at SSRN: https://ssrn.com/abstract=3014149 or http://dx.doi.org/10.2139/ssrn.3014149

Christian Hofmann

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management) ( email )

Kaulbachstr. 45
Munich, DE 80539
Germany

Steven J. Huddart (Contact Author)

Pennsylvania State University, University Park - Department of Accounting ( email )

University Park, PA 16802-3603
United States
814-863-0448 (Phone)

HOME PAGE: http://directory.smeal.psu.edu/sjh11

Thomas Pfeiffer

University of Vienna - Accounting and Control ( email )

Oskar-Morgenstern-Platz 1
Vienna 1090, Vienna
Austria
+43-1-4277-38002 (Phone)
+43-1-4277-38004 (Fax)

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