Choice of performance measures in performance-vested equity compensation and future performance

Abstract

This paper examines the choice of performance measures in performance-vested (p-v) equity compensation and its relation with future performance. Based on a sample of the S&P 500 industrial firms which granted p-v equity compensation to executives during 2006-2008, this paper presents several interesting results. While annual bonuses and p-v equity compensation both link payout to achievement of performance targets, firms use performance measures in different ways for these two types of compensation. Compared to annual bonuses, p-v equity compensation features fewer numbers of performance measures and a higher tendency to use market measures. The results of logistic regressions show that consistent with the Informativeness Hypothesis, the likelihood of a performance measure’s usage in p-v equity compensation decreases with the relative noise of the measure. The choice of performance measures is also associated with financial performance, business complexity, and growth opportunities. Importantly, I find that firms choosing cash or non-financial measures for p-v equity compensation have worse operating and stock performance in subsequent years and firms using a sales measure for p-v equity compensation have better operating performance subsequently. This paper provides useful insights into academia and practice on the design and consequence of p-v equity compensation.