Use Of Equity-based Compensation Research Articles

Non-financial performance measures, CEO compensation, and firms’ future value

This study examines whether non-financial performance measures (NFPMs) included in CEO bonus contracts are complementary to equity-based compensation, and whether they jointly explain future firm value. We predict that in a performance evaluation system, NFPMs integrated into CEO bonus contracts complement the use of equity-based compensation, and that they are jointly and positively associated with firms’ long-term value. Consistent with our predictions, we find that the inclusion of NFPMs in bonus contracts is positively associated with the relative importance of equity-based compensation (especially in the form of restricted stocks), indicating a complementary relationship between NFPMs and equity-based compensation. We also show that equity-based compensation is marginally associated with higher future firm value when the firm uses NFPMs in its CEOs’ bonus contracts. Overall, our findings suggest that equity-based compensation is more effective in aligning managerial efforts and actions with firms’ long-term value when firms include NFPMs in CEO bonus contracts.

The effect of financial reporting quality on CEO compensation structure: Evidence from accounting comparability

This study examines the effect of accounting comparability on the design of CEO compensation structure. After controlling for firm-specific attributes, we find that accounting comparability is positively associated with CEO equity-based compensation intensity and pay-performance sensitivity. This suggests that the improved comparability increases the usefulness of equity-based compensation and a firm is willing to offer more equity-based compensation contracts to CEOs and increase their pay-performance sensitivity. Further, we find that the impact of comparability on the CEO’s compensation contract increases with information asymmetry, which is consistent with the notion that accounting comparability is a quality of financial reporting that facilitates the use of equity-based compensation in a poor information environment. Our analysis also reveals that the effect of accounting comparability on CEO compensation structure is greater when a firm’s corporate governance is strong, consistent with the complementary relation between comparability and the exiting corporate governance in determining CEO compensation schemes. Overall, our evidence suggests that firms utilize more equity-based compensation as a proportion of total compensation under greater accounting comparability and enhance the alignment between equity-based compensation and firm performance.

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This study examines the effect of accounting comparability on the design of CEO compensation structure. After controlling for firm-specific attributes, we find that accounting comparability is positively associated with CEO equity-based compensation intensity and pay-performance sensitivity. This suggests that the improved comparability increases the usefulness of equity-based compensation and a firm is willing to offer more equity-based compensation contracts to CEOs and increase their pay-performance sensitivity. Further, we find that the impact of comparability on the CEO’s compensation contract increases with information asymmetry, which is consistent with the notion that accounting comparability is a quality of financial reporting that facilitates the use of equity-based compensation in a poor information environment. Our analysis also reveals that the effect of accounting comparability on CEO compensation structure is greater when a firm’s corporate governance is strong, consistent with the complementary relation between comparability and the exiting corporate governance in determining CEO compensation schemes. Overall, our evidence suggests that firms utilize more equity-based compensation as a proportion of total compensation under greater accounting comparability and enhance the alignment between equity-based compensation and firm performance.

The effect of say on pay on CEO compensation and spill-over effect on corporate cash holdings: Evidence from Australia

We examine the impact of Australia's Remuneration Amendment Act 2011 on CEO compensation and its spill-over effect on cash holdings to better understand how the new legislation affects the principal–agent relationship. Using a sample of ASX top 300 firms from 2004 to 2015, we find that the Act leads to more use of equity-based compensation. We also document that, after the introduction of the Act, CEO equity-based and total compensations are negatively related with cash holdings, i.e., more equity and total compensations lead to lower cash holdings (a spill-over effect), indicating alignment of the principal–agent interests. Our results are robust to different estimation techniques. Our findings confirm that the Act is effective in driving a more efficient CEO pay strucure and provide important insights for the global discussion on compensation regulations.

Takeovers and (Excess) CEO Compensation

We study if a CEO’s equity-based compensation affects the expected value generation in takeovers. When the objectives of management and shareholders are more aligned, as proxied by the use of equity-based compensation, more value-maximizing acquisitions are expected. Whereas in widely-held firms the decision power is with the management, in firms with concentrated ownership the decision power may be with major blockholders. This may entail that ownership concentration and equity-based pay are substitutes. We find a strongly positive relation between equity-based compensation and cumulative abnormal announcement returns at take-overs, but this relation is eroded when dominant share blocks are held by corporations, which confirms the substitution effect. Powerful CEOs in companies with weak boards and without actively monitoring shareholders may set their own pay which could lead to excesses. We relate excess pay to how takeover decisions are received by the market, and demonstrate that excess compensation negatively affects the acquirer’s stock valuation at a takeover announcement. The market is thus able to identify firms with agency problems and is cautious in its expectations about potential value creation by means of acquisitions.

Takeovers and (excess) CEO compensation

We study if a CEO’s equity-based compensation affects the expected value generation in takeovers. When the objectives of management and shareholders are more aligned, as proxied by the use of equity-based compensation, more value-maximizing acquisitions are expected. Whereas in widely-held firms the decision power is with the management, in firms with concentrated ownership the decision power may be with major blockholders. This may entail that ownership concentration and equity-based pay are substitutes. We find a strongly positive relation between equity-based compensation and cumulative abnormal announcement returns at takeovers, but this relation is eroded when dominant share blocks are held by corporations, which confirms the substitution effect. Powerful CEOs in companies with weak boards and without actively monitoring shareholders may set their own pay which could lead to excesses. We relate excess pay to how takeover decisions are received by the market, and demonstrate that excess compensation negatively affects the acquirer’s stock valuation at a takeover announcement. The market is thus able to identify firms with agency problems and is cautious in its expectations about potential value creation by means of acquisitions.

What have we learned from SFAS 123r and IFRS 2? A review of existing evidence and future research suggestions

The fundamental change in accounting rules for equity-based compensation (EBC) instituted by SFAS 123, SFAS 123r, and IFRS 2 has allowed for new insights related to a variety of research questions. This paper discusses the empirical evidence generated in the wake of the new regulation and categorizes it into two broad streams. The first stream encompasses research on the changed use of EBC and the incentives provided. The second stream addresses how firms account for EBC, including the underreporting phenomenon and how it was affected by the mandatory recognition of EBC expenses. I discuss where research delivers unanimous findings versus contradictory results. Using these insights, I make recommendations for further research opportunities in the area of EBC.

CEO compensation, family control, and institutional investors in Continental Europe

This paper investigates the impact of family control and institutional investors on CEO pay packages in Continental Europe, using a dataset of 754 listed firms with 3731 firm-year observations from 14 countries during 2001–2008. We find that family control curbs the level of CEO total and cash compensation, and the fraction of equity-based compensation. Moreover, we do not observe a significant effect of family control on the excess level of total and cash compensation. This evidence indicates that controlling families do not use CEO compensation to expropriate wealth from minority shareholders. We show that institutional ownership is associated with higher levels of CEO cash and total compensation in Continental Europe, especially in family firms. Also, foreign institutional investors have a positive and significant impact on CEO compensation level. Finally, results indicate that institutional investors affect CEO pay structure: they increase the use of equity-based compensation in both family and non-family firms.

Institutional Trader Monitoring and Firm Performance

Although recent research show that institutional informed trading can spur CEOs to work harder and reduce agency costs even for firms with dispersed ownership structure, it leaves unaddressed the ultimate impact of informed trading on firm value. This paper provides empirical evidence and finds that firm value indeed increases in institutional trader monitoring. In particular, the results confirm that the positive effect of institutional trader monitoring on firm value outweighs the negative effect of potentially increasing agency costs due to the reduced use of equity-based compensation to CEOs, revealed by Chen and Swan (2010). The results are robust to various measures of performance (stock returns, Tobin’s Q, and ROA) as well as to different specifications dealing with the issue of endogeneity.

Rethinking “Strength of Incentives” for Executives of Financial Institutions

The recent crisis has caused some finance theorists and practitioners to rethink the effects of managerial incentives on the total enterprise value of large financial institutions. This re-examination has identified and analyzed a number of potential problems with the use of equity-based compensation, including insufficiently long managerial time horizons as well as the temptation for excessive risk-taking provided by “asymmetric” payoff structures in which shareholders have virtually all the upside while debtholders bear most of the downside risk. In an attempt to address such problems, finance and governance scholars have increasingly explored the possible value of aligning managerial interests with those of not only shareholders, but other important corporate claimants such as debtholders and taxpayers. After reviewing the latest thinking about risk and managerial incentives at financial institutions, the authors come to the following conclusions: • The design of incentives for value maximization needs to reflect a healthy appreciation of downside risk as well as upside reward, and both senior and subordinated debt may be ideal instruments for establishing that balance. At the same time, most senior executives should continue to receive equity-linked compensation in addition to significant proportions of “inside debt.” • Since decision-makers below the highest level executives of large financial institutions collectively wield enormous power to assume and manage risks, this “upper-middle” tier of managers deserves special attention. Rather than rewarding these managers with stock or options, the authors suggest use of a combination of uncapped but “held-at-risk” bonuses denominated in subordinated inside debt as the best way of rewarding effort and competence while controlling opportunities for risk-shifting.

Globalization and Executive Compensation: An Analysis of Pay Practices in U.K. Companies

This paper examines the impact that interactions with the United States market have on the compensation practices of non-US firms. We find strong evidence that the total compensation of UK executives is positively related to the extent of the firm’s interaction with the US market, as captured by the percentage of total sales generated in the US, the presence of prior US acquisition activity and the presence of a US exchange listing. Further tests reveal that UK firms with higher levels of US sales utilize greater levels of bonus pay and are more likely to issue option grants, while UK firms listed on a US exchange offer their executives higher average salaries than their non-listed peers. Executives of UK firms engaging in a US exchange listing experience a significant increase in total cash and salary-based compensation in the year following the listing event. Executives of firms engaging in their first acquisition of a US business experience a significant increase in the relative use of equity-based compensation in the year following the acquisition. Together, this evidence is consistent with US market interactions impacting UK compensation practices through two sets of incentives: (1) to alleviate internal and external pay disparities arising from the presence of US operations and businesses (proxied by percent US Sales and US acquisitions) and (2) to compensate executives for bearing the additional risk associated with exposure to US securities laws and legal environment (proxied by a US exchange listing).

Employee sentiment and stock option compensation

The use of equity-based compensation for rank-and-file employees is a puzzle. We analyze whether the popularity of option compensation may be driven by employee optimism, and show that optimism by itself is insufficient to make option compensation optimal. The crucial insight is that firms compete with financial markets as suppliers of equity to employees and that employees’ access to the equity market restricts firms’ ability to profit from employee optimism. Firms must be able to extract some of the implied rents even though employees can purchase company equity in the financial markets. Such rent extraction becomes feasible if employees prefer the stock options offered by firms to the equity offered by the market, or if the traded equity is overvalued. We provide empirical evidence that firms use broad-based option compensation when boundedly rational employees are likely to be excessively optimistic about company stock, and when employees are likely to strictly prefer options over stock.

The Structure of Executive Compensation: International Evidence from 1996-2004

The primary objective of this study is to better understand the time-series and cross-sectional variation in the structure of executive compensation for non-U.S. firms. That is, has the globalization of labor markets for senior management led non-U.S. firms to design compensation contracts similar to those of U.S. firms or, are there country-specific factors that may cause compensation structures to differ? Using data from 36 non-U.S. countries over 1996-2004, we document significant cross-country differences in compensation structure (i.e., relative use of equity-based and cash-based compensation). The primary determinants of this cross-sectional variation are institutional factors related to the legal environment in each country. Specifically, firms use more equity-based compensation in countries that provide stronger protection of shareholder's rights or have English common-law legal origins. Similarly, firms in countries providing strict enforcement of the rule of law use more equity-based compensation. In addition to these institutional determinants, we find some evidence that the relative use of equity-based compensation is also affected by the firm's agency costs of debt and equity. The data indicate that non-U.S. firms with higher growth opportunities (and the resultant larger agency costs of equity) use relatively more equity-based compensation. We also find that larger firms and firms with lower free cash flow use more equity-based compensation. These findings are consistent with those documented by Yermack (1995) and Bryan et al. (2000) for U.S. firms. However, unlike in the U.S., our data indicate that the agency problems of debt have only a limited effect on compensation structure. Therefore, while the agency theory tested with U.S. compensation data is broadly portable to other markets, the explanatory power is not as significant when applied to non-U.S. firms. We also track compensation structures throughout the time period and seek to identify and explain relative differences between compensation polices of U.S. and non-U.S. firms. The data allow us to test whether compensation structure has converged (as would be suggested by the globalization of financial markets). Alternatively, cross-country institutional differences would suggest a continued divergence in compensation policies across nations. The data provide no evidence of international convergence of compensation structures. Our empirical analysis attributes these pervasive differences to institutional factors. That is, despite the substantial changes in capital market conditions throughout the sample period, institutional factors remain as significant determinants of compensation structure and appear to contribute to consistent cross-country differences in compensation structure.

The Growth of Executive Pay

This paper examines both empirically and theoretically the growth of US executive pay during the period 1993–2003. During this period, pay has grown much beyond the increase that could be explained by changes in firm size, performance, and industry classification. Had the relationship of compensation to size, performance, and industry classification remained the same in 2003 as it was in 1993, mean compensation in 2003 would have been only about half of its actual size. During the 1993–2003 period, equity-based compensation has increased considerably in both new-economy and old-economy firms, but this growth has not been accompanied by a substitution effect, i.e. a reduction in non-equity compensation. The aggregate compensation paid by public companies to their top-five executives during the considered period added up to about $350 billion, and the ratio of this aggregate top-five compensation to the aggregate earnings of these firms increased from 5 per cent in 1993–5 to about 10 per cent in 2001–3. After presenting evidence about the growth of pay, we discuss alternative explanations for it. We examine how this growth could be explained under either the arm's-length bargaining model of executive compensation or the managerial-power model. Among other things, we discuss the relevance of the parallel rise in market capitalizations and in the use of equity-based compensation.

Employee Sentiment and Stock Option Compensation

The use of equity-based compensation for employees in the lower ranks of large organizations is a puzzle for standard economic theory: undiversified employees should discount company equity heavily, and any positive incentive effects should be diminished by free rider problems. We analyze whether the popularity of option compensation for rank and file employees may be driven by employee optimism. We develop a model of optimal compensation policy for a firm faced with employees with positive or negative sentiment, and explicitly take into account that current and potential employees are able to purchase equity in the firm through the stock market. We show that employee optimism by itself is insufficient to make equity compensation optimal for the firm. Any behavioral explanation for equity compensation based on employee optimism requires two ingredients: first, employees need be over-optimistic about firm value, and second, firms must be able to extract part of the implied rents even though employees can purchase company equity in the market. Such rent extraction becomes feasible if employees prefer the non-traded compensation options offered by firms to the traded equity offered by the market, or if the traded equity is overvalued. We then provide empirical evidence confirming that firms use broad-based option compensation when boundedly rational employees are likely to be excessively optimistic about company stock, and when employees are likely to have a strict preference for options over stock.

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

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.

Incentive Compensation for Bank Directors: The Impact of Deregulation

Although industry deregulation leads to changes in the scale and scope of the duties of the board of directors, little is known about the changes in incentives for directors surrounding such events. The deregulation of the U.S. banking industry and associated technological and regulatory changes during the 1990s lends itself to a natural experiment. These industry shocks forced bank boards of directors to face expanded opportunity sets, increased competition, and a rapidly expanding market for corporate control. While bank directors receive significantly less equity-based compensation throughout most of our sample period, by the end of the decade their use of equity-based compensation is indistinguishable from a matched sample of industrial firms. Moreover, banks utilizing a high degree equity-based compensation for directors are associated with higher performance and higher growth without a similar increase in risk. The increase in the use of equity-based compensation for bank directors is not due to a fundamental shift in bank boards, as board size and independence have remained static. Overall, our results suggest that firms respond to deregulation by improving internal monitoring through aligning directors' incentives with those of shareholders.