Too Much Is Not Enough: Incentives in Executive Compensation

By Robert W. Kolb | Go to book overview

6
Executive Incentives and Risk Taking

As previous chapters discussed, a revolution in executive pay in the United States began in the early 1990s with a conscious effort to incentivize top executives to undertake risky projects with the aim of increasing firm value. We also noted that these incentives work principally through compensation vehicles linked to equity, most notably restricted stock and ESOs, with ESOs being the far more powerful incentive tool.

When we think of a standard ESO, one that is issued at-the-money, such an option has considerable, even enormous, value. But that value is inaccessible when it is issued because of vesting restrictions and the nontradability of ESOs. While the option may have great value, there are other impediments to the CEO turning the option into cash. Most notably, the option will not have exercise value unless the stock price rises from where it stood on the date of issue. If the stock price never moves, the option will vest, and the executive may hold it until it expires worthless on its expiration date. From this point of view, the option is worthless unless something positive happens to the stock price—or unless the CEO acts to increase the value of the firm’s shares.

Let us assume momentarily that the CEO is the chief driver of firm value. If she acts, she can hope to increase firm value and make her options pay off when she eventually exercises them. If she does not act, the options will expire worthless. The executive might well reason that the options are inherently worth zero cash value, but that they can possibly be turned into something valuable by taking risks. From this perspective, there is little or no downside to the option’s value. They cannot pay less than zero; the eventual yield in the absence of a stock price increase. Thus, the CEO’s holding of a substantial portfolio of ESOs provides a strong personal incentive to try nearly anything to increase the stock price. If the CEO is paid only with ESOs, she has every reason to “swing for the fences”—that is, she has the ultimate incentive to increase risk.

While firms may wish CEOs to be more accepting of risk in pursuit of greater firm value, they certainly do not want the CEO to adopt wildly risky strategies. Shareholders, in particular, want the firm to undertake risky projects that have a commensurate probability of generating high returns.

-104-

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