Abstract
This paper presents a real-options model of entrenchment in which a CEO chooses how much effort to put into boosting a firm’s productivity and the board and CEO bargain over executive-compensation and investment policies. The surplus that bargaining allocates derives from the reduction in value of the firm’s capital that occurs if the CEO is replaced. Even if the CEO has no ownership stake, she exerts effort in order to increase the value of the capital at risk. This increases the shared surplus, which increases the CEO’s current pay. Newly appointed CEOs are paid less and work harder than their entrenched counterparts. They exert more effort at firms where the CEO’s human capital is more important. In contrast, entrenched CEOs exert more effort at firms where their human capital is less important and turnover-induced disruption has a higher cost. Both types work harder when average productivity growth is higher and productivity growth is more sensitive to effort. The board and CEO will agree to accept a degree of investment inefficiency if this allows them to slow down the CEO’s entrenchment.
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