Stocks or Options? Moral Hazard, Firm Viability, and the Design of Compensation Contracts
49 Pages Posted: 13 Feb 2005
Date Written: February 2005
We consider the problem of providing a risk averse manager effort incentives in a setting where there is a binding minimum that can be paid. An implication is that the contract may be strictly preferred by the manager to outside opportunities. We show that stocks can dominate options as a means of motivation only if non-viability risk is substantial, as in financially distressed firms or start-ups. Options dominate stocks for all other firms. These results hold regardless of the existing portfolio of the manager or the risk of being fired. The basic theoretical insight also illuminates the role of bonuses based on the stock price, the behavior of compensation over time, and the way in which compensation changes as a firm moves between different parts of its life-cycle, as for example, as a startup progresses from the pre to post IPO stages, or a foundering firm emerges from bankruptcy. While this is primarily a theoretical paper, we provide some evidence that low bankruptcy risk is indeed correlated with less use of stock.
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