Equity-Based Incentives and Effective Signalling Strategies

Abstract

We investigate how the manager of a publicly traded firm may distort operational decisions to signal product quality when he/she receives equity-based incentives offered by shareholders. We show that the shareholders' optimal incentive contract induces the manager to engage in wasteful actions. However, the cost of such actions can be drastically reduced by optimising the equity-based incentive contract. The price-signalling strategy is nearly as good as the multidimensional strategy, whereas the inventory-signalling strategy is costly for the shareholders. We also quantify how various parameters could affect shareholder wealth and the optimal equity-based incentive contract.

Keywords: Equity-based incentives, multidimensional signalling games, mechanism designs

JEL Classification: D82, D86