Executive Pay, Innovation, and Risk‐Taking

• DOI: http://doi.org/10.1111/jems.12090
• Author: Volker Laux
• Date: 01 June 2015
• Published date: 01 June 2015

Executive Pay, Innovation, and Risk-Taking

VOLKER LAUX

Department of Accounting

University of Texas at Austin

Austin, Texas

volker.laux@mccombs.utexas.edu

This paper analyzes the optimal equity pay mix in a setting in which executives face career

concerns and must be motivated to search for innovative investment ideas and to make appropriate

decisions regarding whether to pursue the uncovered idea. I show that, depending on the value

of the firm’s potential growth opportunities and the CEO’s concern about being fired, the CEO

is either tempted to overinvest in risky ideas (excessive risk-taking) or underinvest in risky ideas

(excessive conservatism). The optimal pay package consists of stock options, to encourage the

discovery of innovative ideas, and either restricted stock, to combat excessive risk-taking, or

severance pay, to combat excessive conservatism. The model provides new empirical predictions

relating executive pay arrangements to the importance of innovation and career concerns and

analyzes how the change in the economic environment caused by the current financial crisis

might change the optimal mix of stock options, restricted stock, and severance pay.

1. Introduction

In the wake of the recent economic crisis, executive equity compensation has come

under increased public scrutiny. A key complaint is that stock option plans have caused

excessive risk-taking, which contributed to the financial meltdown in 2008 (Samuelson

and Stout, 2009). To respond to these concerns, policymakers and regulatorshave taken

steps to restrict executive pay arrangements in public corporations. For example, the

economic stimulus bill passed in mid-February 2009 prohibits Troubled Asset Relief

Program (TARP) recipients from paying its senior executives any form of incentive

compensation except long-term restricted stock and bans the use of severance pay.1

The goal of this paper is to develop a model that can address the following ques-

tions: What are the determinants of the optimal mix of restricted stock, stock options,

and severance pay in executive compensation and what specific roles do these incen-

tive instruments play? In what way do career concerns affect the optimal combination of

these incentive instruments? Did the change in the economic environment caused by the

financial crisis change the optimal mix of restricted stock, stock options, and severance

pay, and if so, how?

I study these questions in a setting in which the CEO must be motivated to exert

effort to search for new and innovative investment ideas and, if he successfully uncovers

one, to make an appropriate decision regarding whether or not to pursue the new idea.2I

I thank an anonymous coeditor, an anonymous referee, Bill Kinney, Christian Laux, Paul Newman, Richard

Saouma, and seminar participants at McGill University and the American Accounting Association for their

valuable comments.

1. American Recovery and Reinvestment Act of 2009, H.R. 1, 111th Cong. Section 7001.

2. Other studies that consider the dual problem of inducing effort and efficient decision making include,

for example, Lambert (1986), Demski and Sappington (1987), Levitt and Snyder (1997), and Inderst and Klein

(2007).

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 2, Summer 2015, 275–305

276 Journal of Economics & Management Strategy

assume that the success probability of the new idea depends on a signal about its quality

(which is the CEO’s private information) and on the CEO’s type. The type reflects

whether the CEO, who uncovers the new idea, is also the right person to implement it.

Low intermediate cash flows signal negative information about the CEO’s fit and lead to

the incumbent’s replacement. Thus, adopting new ideas is associated with greater risks

for the incumbent CEO (compared to continuing business as usual) in that it increases the

chances that he will be replaced with a new CEO who is expected to be better suited to

implement the new project. Following Holmstrom (1999), I assume that the incumbent’s

fit is initially unknown to all parties.3

To encourage the discovery of innovative ideas, the board has to design a pay

scheme that provides the CEO with a greater expected payoff if he implements a new

idea than if he continues business as usual. This can effectively be done by offering a

combination of stock options and severance pay. Restricted stock, on the other hand, is

strictly less effective in motivating the CEO to uncover innovations because shares of

stock also reward him for simply continuing business as usual. The result that severance

pay can be used to induce discovery effort stands in sharp contrast to the standard view

that such payments dilute effort incentives (e.g., Bebchuk and Fried, 2004). Severance pay

protects the CEO from the cost of dismissal and hence makes the adoption of innovative

and risky ideas more attractive, which in turn motivates management to search for those

ideas in the first place.4For the purpose of providing incentives for discovery effort, the

relative mix of stock options and severance pay is not important. However, the relative

mix is important for the CEO’s decision to adopt the innovation once he has discovered

one. To determine the optimal executive pay plan, two cases need to be considered.

Consider first an environment in which innovation and growth are crucial for

firms’ future performance and in which executives are less worried about the risk of

losing their position (because, for example, it is relatively easy to find a new job with

comparable benefits). In this case, the challenge is to provide the CEO with strong

incentives to search for new ideas without inducing excessive risk-taking once a new

idea is discovered. Although both stock options and severance pay are effective in

inducing discovery effort, the former is strictly preferred over the latter because stock

options render those ideas more attractive that are likely successful whereas severance

pay renders those ideas more attractive that are likely unsuccessful. Thus, the advantage

of stock options over severance pay is that they effectively induce the discovery of new

ideas without creating excessive distortions when it comes to the investment decision.

Nevertheless, when the size of the stock option grant is large relative to the disutility of

being fired, the CEO might still be tempted to overinvest in risky ideas. To resolve this

issue, the board has to replace some of the stock options with restricted stock. Restricted

stock is less effective in inducing discovery effort but makes it more costly for the CEO to

take excessive risks and hence helps to implement the appropriate investment decision.

Thus, the model predicts that in firms and industries where innovation and growth is

key for the future performance and where executives’ concern about being fired is mild,

3. See also Narayanan (1985), Holmstrom and Ricart i Costa (1986), and Hirshleifer and Thakor (1992) for

studies that analyze the impact of career concerns on investment decisions.

4. Almazan and Suarez (2003) demonstrate a positive role of severance pay in providing effort incentives

in a setting in which (i) effort is observable but non-contractible and (ii) the CEO has the power to resist his

own replacement. In their model, the CEO knows that he can tease out additional severance pay (by credibly

threatening to oppose his replacement) only if he has taken the desired action, implying that the renegotiated

increase in severance pay constitutes a direct reward for effort.For an overview of potential roles of severance

pay in optimal contracting, see Edmans and Gabaix (2009).