Abstract
Besides the commonly cited reasons for the use of stock options, including motivating employees, conserving cash, exploiting favorable accounting and tax treatment, and retaining managers, we demonstrate a complementary benefit of option-based compensation: options also prove efficient in matching managerial pay to ability. Options are useful because they force a manager to put his pay on the line. If a manager wants to overstate his worth to the firm, he must naturally also overstate the firm's worth with him at the helm. As a result, the firm offers a generous package of stock options in lieu of cash for assertions of high ability. Since both the likelihood of option exercise and firm value in the event of exercise are tied to managerial ability, only a gifted manager takes such a gamble.
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