Executive Compensation: A Firm Life Cycle Analysis

Abstract

This study uses the firm life cycle framework to extend our understanding of firm contracting practices. First, based on the theory of firm characteristics and the nature of firm transactions in each life cycle stage, we document significant differences in both the level and mix of executive compensation across firm life cycle stages. We next use economic predictions of the sensitivity and precision (signal-to-noise ratio) of accounting and market measures of performance across life cycle stages to examine variation in the weighting of underlying performance measures used in compensation contracting. Consistent with theory, we find that compensation is most sensitive to accounting measures in the mature stage when these measures are stable and informative of manager effort. Alternatively, forward-looking measures of performance are most heavily weighted in the early and late stages of a firm’s life cycle when historical accounting performance measures are less timely and relevant. Additionally, we allow the relation between economic determinants and total compensation to vary by life cycle stage and find that stage-specific compensation models more fully predict total compensation (i.e., larger adjusted R-squared, smaller residuals). Finally, we expand traditional excess compensation and rent extraction models to allow for life cycle variation and find our inferences on rent extraction change significantly. Overall, our results suggest that across life cycle stages, firms operate in different contracting environments that lead to differences in the executive compensation contract design. Our results suggest care should be taken in evaluating compensation on a broad cross-section of firms in different life cycle stages.