Performance Periods in CEO Performance-Based Restricted Stock Compensation: Theory and Evidence

Abstract

This paper examines the length of performance periods, the period of time over which the executive’s performance is evaluated, in CEO performance-based compensation, particularly performance-based equity awards (PBEAs). Traditional compensation risk and governance considerations identify advantages of longer performance periods, but a performance appraisal perspective (Lazear 1986) establishes when shorter performance periods are preferred because they more efficiently sort CEO talent. We develop a sorting model based on this insight and demonstrate that the length of performance periods in PBEAs decreases with a CEO’s expected productivity and alternative employment opportunities, as well as with the firm’s operating uncertainty and the dispersion of CEO productivity. We then test and find empirical support for these predictions in a sample of S&P 1500 industrial firms granting PBEAs to CEOs. Further analysis shows that sorting affects the performance period length of incentive compensation mix, which includes annual and long-term cash bonuses in addition to PBEAs. We also document that CEO turnover is higher for underperforming CEOs with shorter performance periods, consistent with the importance of a sorting function in performance period design.