«Published Annually Vol. 6, No. 1 ISBN 978-0-979-7593-3-8 CONFERENCE PROCEEDINGS Sawyer School of Business, Suffolk University, Boston, Massachusetts ...»
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Compensation contracts used in different firms embody both incentive and risk sharing components. This study builds on the existing literature by empirically investigating the relationship between executive risk sharing and the firm’s stock performance in new and old economy firms. It tries to answer the fundamental question of whether or not using risk sharing contracts actually motivate executives to increase shareholder value, and whether that effect differs between new and old economy firms. The results indicate that the level of risk sharing does not influence the future market value of firm shares. However, it does negatively influence the current and future return to shareholders in all but new economy firms. These results held regardless of the level of risk sharing. The results also indicate that more intensive stock-based contacts positively influence current and future stock performance. This indicates that although stock based compensation includes a level of risk sharing, the level of risk sharing is not what drives stock performance. Rather, it is the value of the stock based compensation that drives performance leading to a higher market value per share and higher return to shareholders. This result appears to be much more pronounced in new economy firms due to the structure of their compensation contracts.
Key Words: executive risk sharing, stock performance, new economy firms
There is a growing line of research on the relationship between executive compensation and firm performance in publicly owned corporations. Much of that research employs the agency theory to explain incentives in compensation contracts and performance (e.g., Indjejikian, 1999; Bushman and Indjejikian, 1993; Lambert and Larcker, 1987). The common proposition underlying this line of research is that in order to motivate executives to spend effort and work for the best interest of the shareholders, compensation contracts should include some form of incentive component (Hays and Schaefer, 2000; Indjejikian, 1999; Baber et al., 1999; Sloan, 1993). Such an incentive component should establish a link between executive compensation and the performance of the firm they manage. Shareholders are mainly interested in the value of the firm and the stock return they receive. Executive compensation can be used as an effective instrument for creating value for shareholders by improving their firm’s performance (Gong, 2010; El Akremi et al, 2001).
Recent survey studies show that performance measures and the structure of incentive contracts vary substantially across firms and industries (Indjejikian, 1999). This is even more evident in new economy firms, where stock-based compensation is extensively used compared to old economy firms (Vieito et al., 2008; Murphy, 2003; Ittner et al., 2003; Anderson et al., 2000). Even with the differences in compensation contracts used in different firms, and whether compensation is linked to firm performance measured by accounting information or the performance of the share price in the market, it embodies both the incentive and risk sharing effects (Gomaa, 2003).
Despite the richness of executive compensation literature, most of the research is limited to CEO contracts, and concerned with issues related to the examination of the determinants of compensation contracts, and how to design an optimal contract that aligns CEOs and shareholders objectives. Research on compensation risk, risk sharing and the consequences of using different types of incentive contracts on firm performance has also been limited due to the lack of good empirical measures (Abdel-khalik, 1998). His results provide evidence that risk-sharing in compensation contracts has a significant effect on shareholders rate of return. Other studies tried to examine whether or not incentive contracts actually motivate executives
Conference papers © Knowledge Globalization Institute, Pune, India, 2012
(Leonard, 1990; Abowd, 1990). These studies tried to investigate the impact of incentives on stock-market return. Murphy (2003), Ittner et al (2003) and Anderson et al. (2000) tried to examine the same issue in new economy firms. They argue that the extensive use of equity grants by new economy firms has allowed them to improve performance and provide incentives for executives to enhance shareholder value (Ittner, 2003). The results of these studies suggest that there is a relationship between risksharing and firm performance, and that such a relationship is significantly different in new economy firms from that of the old economy firms.
This study builds on the existing literature by empirically investigating the relationship between executive risk sharing and firms’ stock performance in new and old economy firms. It tries to answer the fundamental question of whether or not using risk sharing contracts actually motivate executives to increase shareholder value, and whether that effect differs between new and old economy firms. This study is motivated by: (1) the lack of conclusive evidence in the existing literature about the effect of risk sharing on firm’s stock performance, (2) the lack of evidence on the relationship between incentives given to top executives’, other than the CEOs, and firm’s stock performance, and (3) the emergence of a new line of research concerned with the new economy firms, and the relationship between the incentive contracts use in these firms and their success.
Consistent with prior research, this study employs the agency framework to establish a theoretical framework for analysis. It contributes to the existing literature by providing additional evidence on the effect of risk sharing on stock performance and investigating that relationship in both new and old economy firms. The study does not limit its investigation, as most of the existing research did, to the relationship between CEO compensation and firm performance. The effect of risk sharing and other incentives in compensation contracts is also examined.
The study results show that the level of risk sharing does not influence the future market value of firm shares. However, it does negatively influence the current and future return to shareholders in high-risk sharing, low-risk sharing, and old economy firms, but not in new economy firms. The results also indicate that more intensive stock-based contacts positively influence current and future stock performance. These results indicate that even though stock based compensation contracts include a level of risk sharing, the level of risk sharing is not what drives stock performance. Alternatively, it is the value of the stock based compensation that drives performance leading to a higher market value per share and higher return to shareholders. This result appears to be much more pronounced in new economy firms where stock-based compensation is extensively used compared to old economy firms.
The remainder of this paper is organized as follows: Section II presents the theoretical background and hypotheses development, followed by the research design in Section III. The results of the study and the analysis of results will be presented in Section IV. Finally, Section V will include concluding remarks.
The relationship between shareholders and top executives in publicly owned corporations is a classic example of the principle-agent relationship described in the agency theory literature. In a typical agency relationship, the principal hires an agent to act on his/her behalf. Actions taken by the agent have crucial effects on the principal’s wealth, yet these actions are often unobservable to the principle. To induce desired actions, a compensation contract must be designed to give the agent proper incentives. In general, “agency theory predicts that compensation policy will tie the agent’s expected utility to the principal’s objectives” (Jensen and Murphy, 1990, p. 242). They point out that since “the objective of shareholders (in a corporation) is to maximize wealth;
agency theory predicts that CEO compensation policies will depend on changes in shareholder wealth” (Jensen and Murphy, 1990, p, 242). This prediction is based on three postulates: “(1) … there is a potential divergence of interest between shareholders and the CEO, (2) …the existence of an information asymmetry which makes it difficult for the shareholders to (observe) the activities of the CEO, (3) …the CEO, as a rational agent, seeks to maximize his or her utility and at the same time has an aversion of risk” (El Akremi, et al, 2001, p. 6). Due to the high monitoring cost, the shareholders are left with the option to construct contracts based on surrogate measures of performance that align executives and shareholders objectives. The use of surrogates as a basis for contracting between executives and shareholders, however, may result in a reduction in executive’s incentive to exert the proper effort because the surrogates may not capture all of the performance attributes (Holmstrom, 1979). Thus, with imperfect information most agency relationships must deal with the incentive problem.
As outlined in the agency literature, a compensation contract should include two components; a measure of Conference papers © Knowledge Globalization Institute, Pune, India, 2012 performance, and an incentive structure. Recent research shows that different performance measures and incentive schemes are suggested in the literature and used in practice (e.g., Ittner et al., 2003; Murphy, 2003; Kren 2001; Jensen and Murphy, 1990).
The existence of different performance measures and incentive schemes implies that there is no consensus as to their usefulness. Many researchers have examined the relative usefulness of financial measures of performance in designing executive compensation contracts. They examined different types of accounting-based, stock-based and relative measures of performance. The results, however, are not conclusive. Lambert and Larker (1987) argue that accounting measures of performance are less informative than stock-based measures about management performance in high growth firms. Clinch (1991) found similar results in high R&D firms. Other researchers provide evidence in support of the use of accounting-based measures of performance. Shim et al, (1999) investigated the determinants of executive compensation in financial institutions. They found that executive compensation is positively related to financial measures of performance. Bizjak et al. (1993) and Gaver and Gaver (1993), however, argue that accounting-based measures of performance affect investment decisions and encourage managers to emphasize short-term performance. Jensen and Murphy (1990) point out that although academic research has usually found a positive correlation between financial performance and executive compensation, they also noted that the associations are modest and explain little of the variance in compensation.
Recent studies show that there is a growing increase in using stock-based measures of performance in recent years (Ittner et al., 2003; Murphy, 2003; Aggarwal and Samwick (1999); Hall and Liebman, 1998; Yarmack, 1995). This is consistent with the argument that shareholders can induce optimal decisions by structuring managerial compensation contracts to balance both future and current stock performance (Gong, 2010; Bizjak et al., 1993). The results of Bizjak et al., (1993) suggest that firms with high information asymmetries between managers and shareholders will tend to favor contracts that emphasize equity ownership relative to salary and bonus incentives. Such contracts focus on long-term return rather than short-term stock return alone.
The above review suggests that there is no conclusive evidence as to the efficiency of performance measures used in executive compensation contracts. Both accounting-based and stock-based contracts have shortcomings. Existing literature, however, suggest that stock-based contracts provide better incentives for long-term performance.
Risk Sharing in Compensation Contracts
A typical executive compensation contract includes two components: Salary plus some performance-based reward. The performance-based component usually include a cash bonus tied to some accounting measure of performance, stock options, and/or other long-term incentive plans. While salaries are basically fixed, the variability of the performance-based component reflects the level of risk executives share with the owners.
As noted by Abdel-khalik (1998), compensation variability represents only one contractual risk component. Another important element of compensation risk is the executive equity ownership. An executive may acquire ownership of voting shares at present and/or options to acquire equity ownership at future dates.