Executive Compensation and Aspirational Peer Benchmarking

Abstract

Small firms provide an excellent, yet previously unexamined, laboratory for studying the controversial practice of compensation benchmarking since small firms have the opportunity to benchmark against `peers' whose executive compensation eclipses their own. Using a comprehensive, hand-collected dataset of explicit peer group relationships, I document that small firms engage in upward compensation benchmarking to a much greater degree than large firms do. In contrast to the prior literature studying larger firms, small firms choose aspirational peers that reflect their executives' shifting opportunity sets. For these firms, compensation benchmarking is indicative of future growth and performance, and the rate at which pay adjusts toward peer levels is sensitive to the transferability of managers' human capital. Contrary explanations that peer benchmarking is prone to agency problems are not supported by the data. Overall, the data suggest that growing and outperforming small firms strategically and preemptively use upward benchmarking to adjust pay in an effort to retain valuable managerial talent.