The Role of Equity Compensation in Reducing Inefficient Investment in Labor

Abstract

We examine whether equity compensation incentivizes managers to make efficient labor investment decisions. Specifically, we examine whether and how the components of equity compensation – stock options and restricted stock – affect over- (under-) investment in labor. We find that stock options exacerbate (mitigate) over-investment (under-investment) in labor, while, suggesting that giving stock options to managers encourages (discourages) them to over- (under-) invest in labor. In contrast, restricted stock mitigates both over-investment and under-investment in labor, so granting restricted stock to managers discourages them from over- and under-investing. Our results are consistent after controlling for managerial ability and corporate governance. Overall, our research demonstrates that stock options and restricted stock matter in managers’ labor investment decisions.

Keywords: Over-investment, under-investment, labor, stock options, restricted stock, agency, human capital, empire-building, risk-aversion