Abstract
This paper analyzes the optimal design of stock option vesting conditions when the CEO faces a risk of being replaced at an interim date. First, I show that long vesting terms do not necessarily discourage but in fact can encourage short-termism. Second, the model demonstrates that the optimal vesting schedule involves balancing incentives for managerial effort with incentives for long-term investment. Due to this trade-off, overinvestment in myopic projects can arise from optimal contracting and is not necessarily an artifact of faulty pay arrangements. The study generates new empirical predictions regarding the determinants and impacts of stock option vesting terms in contract design.
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