The restricted shares cannot be traded for three years. Finally, executive 3
receives $100,000 cash plus $100,000 worth of warrants. Each warrant gives the
holder the right to purchase the corporation’s stock at a strike price of $100 per
share. Suppose that warrants are trading at $10 per warrant. Executive 3 thus
receives 10,000 warrants.
The three schemes have the same cash value. But which one provides the
greatest incentive to maximize the corporation’s share value three years hence?
Executive 1 received no equity interest in the firm. Her compensation is inde-
pendent of the share price, so she has no direct financial incentive in that
regard. Executive 2 holds 1,000 shares. Therefore, for every dollar that his man-
agement skills can raise the share price, he profits by $1,000. Finally, executive
3 holds 10,000 warrants. For each $1 increase in share price above $100, exec-
utive 3’s 10,000 warrants increase in value by $10,000. (For instance, if the
three-year price is $120, each warrant is worth $20, the difference between the
strike price and the current price.) Thus, the third pay-for-performance
scheme gives by far the greatest executive incentive to maximize share value.614 Chapter 14 Asymmetric Information and Organizational DesignLinking executive compensation to the firm’s performance serves to align man-
agement’s interests with those of shareholders. But how much of the typical
executive’s compensation is actually tied to share price performance in today’s
corporations? Michael Jensen and Kevin Murphy studied compensation for the
chief executive officers of 250 of the largest American corporations and found
that the compensation of most executives did not vary much with company
performance.^27 Jensen and Murphy suggest straightforward measures to
strengthen CEO incentives. First, CEOs should own substantial amounts of
company stock. For instance, the financial wizard Warren Buffet owns almost
45 percent of Berkshire Hathaway, the conglomerate he controls. Obviously,
Buffet has a keen incentive to increase his company’s value. Second, CEO pay
should be tied more closely to performance. Third, companies should fire
poorly performing CEOs (a rare event over the last 20 years, and even fired
executives leave with enormous compensation).
Critics, however, contend that pay-for-performance (PFP) systems have
their own problems. Companies cannot easily measure executive performance;
PFP schemes often reward the wrong types of behavior; and monetary com-
pensation does not always sufficiently motivate behavior. Even proponents of
PFP systems frequently disagree on the appropriate degree of incentives.
Because of year-to-year fluctuations in corporate performance that are outside
the control of the manager, PFP systems frequently produce large variations in
the manager’s compensation. In Chapter 12, we saw that risk-averse agents
require extra compensation to bear these risks. In general, structuring an optimal(^27) See Michael Jensen and Kevin Murphy, “CEO Incentives—It’s Not How Much You Pay, But How,”
Harvard Business Review(May–June 1990): 138–153; Jensen and Murphy, “Performance Pay and
Top-Management Incentives,” Journal of Political Economy(April 1990): 225–264.
Business Behavior:
Executive
Compensation
and Incentives
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