Stock and Option Grants with Performance-Based Vesting Provisions

Abstract

While existing literature on equity-based compensation is focused heavily on stock option and restricted stock awards that carry simple time-based vesting restrictions, we find that more complicated performance-based vesting provisions are quite common. We construct and analyze a novel dataset containing 1,013 equity-based awards with performance-vesting features granted by U.S. firms during the period 1995 through 2001. We examine the characteristics of these compensation plans, the economic rationale for adoption, the valuation and incentive effects of these awards, and the effect of the plan adoptions on managerial behavior. First, we find that these awards either (i) require achievement of specific stock market and accounting targets in order to vest or (ii) have a payout and vesting schedule that depends on performance of the firm relative to peers or an index. These performance-vesting conditions are based primarily on either accounting performance or stock market performance, but there is significant variation in plan design. Second, we find evidence that firms grant these equity awards to increase managerial incentives and also may use these awards as a sorting mechanism for managerial talent. For example, these awards are more likely to be adopted following poor performance and when the firm hires a new CEO. Third, we find that the pay-for-performance sensitivities associated with these awards are economically significant and are higher among firms with poorer prior performance and lower overall levels of prior investment expenditures. Both results suggest that firms design these awards to increase incentives. Finally, we find an increase in investment activity and improved firm performance subsequent to the adoption of these plans.

Keywords: Corporate governance, Executive compensation, Stock options, Performance vesting

JEL Classification: G30, J33