Managerial Incentives, Monitoring, and Risk Bearing: A Study of Executive Compensation, Ownership, and Board Structure in Initial Public Offerings
Beatty, Randolph P., Zajac, Edward J., Administrative Science Quarterly
Organizational theorists have increasingly drawn on agency theory (Ross, 1973; Jensen and Meckling, 1976) to generate an extensive body of research on topics such as executive compensation and corporate governance (e.g., Tosi and Gomez-Mejia, 1989; Zajac, 1990; Davis, 1991; Westphal and Zajac, 1994). In applying or adapting agency theory to these organizational issues, however, it is useful to distinguish between what Jensen (1983: 334-335) referred to as two "almost entirely separate" agency literatures: a normative principal-agent literature that emphasizes the design of compensation contracts with optimal risk-sharing properties (see Levinthal, 1988, for a review) and a positive, empirically based, agency literature that focuses primarily on questions relating to the separation of corporate ownership and control and the role of boards of directors (Fama and Jensen, 1983; Weisbach, 1988; Morck, Shleifer, and Vishny, 1989).
The positive versus normative split in the agency literature has important implications for organizational researchers seeking to explain phenomena such as incentive compensation for top executives. For example, while the positive agency literature highlights the value of placing greater amounts of managerial compensation and managerial wealth at risk by tying it closer to firm performance (e.g., Jensen and Murphy, 1990), the normative agency literature stresses the need to consider the potential disadvantages of forcing managers to bear excessive compensation risk (Holmstrom, 1979, 1987; Shavell, 1979; Stiglitz, 1987; Fama, 1992).
Eisenhardt (1989) noted that organizational research using agency theory has tended to draw from the positive rather than the normative agency literature. One implication of this is that organizational research has generally placed greater emphasis on the importance--from an incentive and control standpoint--of imposing strong pay-for-performance linkages, rather than the possible disadvantages of imposing risk bearing in managerial compensation contracts. The lack of debate in the recent organizational literature on this issue is somewhat surprising, given that the organizational behavior literature on compensation has historically recognized that different forms of compensation, such as pay for performance, vary in their attractiveness to individuals and therefore vary in their appropriateness as incentives and motivational tools (Lawler, 1971; Mahoney, 1979).
A similar, if more subtle divergence has also occurred in the agency-based discussions of monitoring as a means for controlling managerial behavior. Both the normative and positive agency literatures have addressed the relationship between managerial incentives and monitoring. The former examines abstractly the costs and benefits of monitoring as a second-best solution when optimal compensation contracts cannot be written; the latter discusses the benefits, but not necessarily the costs, of the monitoring technology observed in modern corporations (cf. Fama and Jensen, 1983). Again, organizational research has tended to draw more from the positive agency literature in focusing on the effectiveness or ineffectiveness of boards of directors as monitors of top management, without considering explicitly the possible cost-benefit trade-offs between using incentives and using monitoring as alternative sources of controlling managerial behavior.
We argue that resolving the ambiguity and conflict about executive pay-for-performance relationships and corporate control requires a more unified perspective on top management compensation, ownership, and corporate governance. To achieve this goal, we examine both of the potential trade-offs mentioned above and develop hypotheses about the organizational and personal contingencies that may lead to differences across firms in how these trade-offs are addressed. By proposing and testing this contingency perspective with a large sample of initial public offering (IPO) firms, we hope to extend and unify the growing literature on top management compensation, ownership, and corporate governance. …