Executive Pay, Innovation, and Risk-Taking

Abstract

This paper analyzes the optimal executive pay arrangement in a setting in which the CEO must be motivated to search for innovative investment ideas and, if he uncovers one, to implement the idea if and only if it is not excessively risky. I show that, depending on the value of the firm's potential growth opportunities and the CEO's concern about being fired, the CEO is either tempted to overinvest in risky ideas (excessive risk-taking) or underinvest in risky ideas (excessive conservatism). The optimal pay package consists of stock options, to encourage the discovery of innovative ideas, and either restricted stock, to combat excessive risk-taking, or severance pay, to combat excessive conservatism. The model provides new empirical predictions regarding the determinants of executive compensation arrangements and analyzes how the change in the economic environment caused by the current financial crisis might change the optimal mix of stock options, restricted stock, and severance pay.