In Defense of Incentive Compensation: Its Effect on Corporate Acquisition Policy

Abstract

Financial economists have long recognized that compensation design, particularly the use of equity‐based compensation, can provide strong motivation for corporate managers to make value‐maximizing decisions. But the perception of excesses in equity‐based pay for U.S. executives has become pervasive and has led many to question its efficacy. The fundamental problem is one of measurement–while it is relatively easy to measure the cost of equity‐based compensation, it is difficult to determine the extent to which equitybased compensation actually causes managers to direct corporate resources into value‐maximizing ventures.The authors of this article focus on corporate acquisition policy and argue that if equity‐based pay is an effective motivator, it should limit management's inclination to overpay for acquisitions and to make unwise acquisitions. In their study of 1,719 mergers and tender offers over the period 1993–1998, the authors found that bidding companies with higher proportions of equity‐based pay paid lower takeover premiums, acquired targets with stronger growth opportunities, and undertook acquisitions that were received more favorably by the market both upon announcement and over time.