The Temporal Structure of Equity Compensation

Abstract

Linking managerial incentives to payoffs to shareholders provides managers with incentives to act in the shareholders' interest and to enhance shareholder value. Such alignment, when achieved through long-term equity stakes, also imposes risks on managers and leads to excessive managerial conservatism with respect to project risk choice. Shorter term equity-linked incentives can mitigate such managerial risk aversion and lead to more efficient risk-taking. Optimal short-term equity-linked compensation never results in excessive risk-taking by managers of an all-equity firm. However, in the presence of potential debt overhang, short-term equity incentives may lead to excessive risk-taking. Thus, the temporal structure of optimal equity incentives differs amongst industrial and financial firms with high implicit leverage through deposit-taking and an one-size-fits-all approach to managerial compensation across firm-types is not optimal.

Keywords: executive compensation, corporate governance, corporate diversification

JEL Classification: G31, G34, D21, D82