Labor Market Immobility and Incentive Contract Design

Abstract

This study examines the effects of reduced labor market mobility on the exercisability design of executive option compensation. After managers are restricted from working for competitors by the adoption of the Inevitable Disclosure Doctrine, firms lengthen the exercisability schedules of option compensation. Treated firms also increase the use of a progressive performance-based exercisability provision (PPV) in these options, allowing managers to exercise options earlier once they have lost their convexity. The effects increase with managerial career concerns, and with firms’ growth opportunities and dependence on knowledge assets. The findings suggest that under knowledge protection by restricting human capital mobility, firms are more willing to invest in long-term positive NPV projects while managers are not. Firms use options with long-term exercisability to extend managers’ incentive horizon, and condition exercisability on performance to manage one downside of long exercisability: lost convexity when these unexercisable options move deep in-the-money.

Keywords: Labor market mobility, Inevitable disclosure doctrine, Executive compensa¬tion, Options duration, Progressive performance vesting, Risk taking, Human capital investment, Non-patentable innovation

JEL Classification: G30, G34, J33, M52, M54, O31