ORCID

Jeremy Bertomeu, https://orcid.org/0000-0001-6746-5767

Language

English (en)

Publication Date

2008

Abstract

The primary role of equity compensation is to provide incent ives to an effort-averse agent. Here, we show that the chosen level of equity incentives, whe n publicly disclosed, will also convey information about future earnings, causing two-way linkages between incentive com- pensation and financial reporting. If either (a) market pric es respond more (less) to informa- tion, (b) the manager is more (less) risk-averse, (c) earnin gs are more (less) noisy, then the firm’s owners choose more pronounced (muted) incentives, in turn leading to greater (lower) future earnings. The model explains observed spurious corr elations between firm perfor- mance and executive compensation, and provides several new predictions linking managerial, earnings and market determinants to optimal equity holding s. *Kellogg School of Management, Northwestern University, 20 01 Sheridan Road, Evanston, IL 60208-2001. E-mail address: (first name).(last name) at gmail dot com. Phone: 41 2-352-0992. Many thanks to Craig Chapman, Edwige Cheynel, Ron Dye, Pingyang Gao, Ian Gow, Pierre Liang, Rober t Magee, Ivan Marinovic, Mehmet Ozbilgin, Tjomme Rusticus, Sri Sridhar, Yun Zhang, an anonynous referee and o ther seminar participants at the Kellogg brown bag lunch for many helpful suggestions. 1 Over the last decades and following several amendments to SE C Regulation S-K, information available to outside investors about managers’ equity owne rship has become more comprehensive. Managers are required by law to disclose any trade or option e xercise that would affect their equity ownership and firms must disclose new option or stock grants. That such public disclosures could convey information to outside investors is clear: owners in formed on the quality of projects may choose to offer very different levels of incentives to their manager and, thus, investors should be able to make some inferences from contract disclosures. As c ompared to the standard environment where managerial contracts sole purpose is to elicit effort , this “capital-market” role for incentive contracts may distort the choice of incentives as well as the equilibrium level of effort and the pay level. This paper formally examines the economic consequences of p ublic disclosures of managerial equity incentives. In our model, an initial owner has privat e information on the quality of projects, which he cannot credibly disclose. The owner sells the firm an d (contrary to common signaling models) cannot signal quality by retaining ownership.1However, the owner employs a manager who may provide effort and observes the quality of the projec t. The managerial contract has two functions: to elicit effort from the manager at the lowest co st, and to indicate to new investors the quality of existing projects. Examining these two funct ions, we describe the distortions to the optimal compensation contract that this signaling proc ess entails and provide several links between (i) the quality of information available to outside investors, (ii) the stock response to a management contract, (iii) the firm’s future operating perf ormance, and (iv) characteristics of the managemerial contract such as total pay and the level of equi ty incentives. Understanding how much information about future prospects is conveyed through manage- rial stock ownership is of interest as part of the broader lit erature that examines the interactions between contract design and firm performance, on the one hand , and the cost and benefits of dis- closure, on the other hand. An extensive empirical literatu re has examined the association between changes in compensation plans, and stock market reactions a nd/or future operating performance (e.g., Watts and Smith (1992), Gaver, Gaver and Battistel (1 992), Dechow, Hutton and Sloan (1996), Core and Larcker (2002), Hanlon, Rajgopal and Shevl in (2003)). Yet, we are not aware 1In this respect, the model differs from signaling models in w hich the original owner retains, ex-post, “skin” in the game (e.g., Leland and Pyle (1977), Hughes (1986), Kanodia a nd Lee (1998)). 2

Document Type

Working Paper

Author's Department

Accounting

Author's School

Olin Business School

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