The Participation Constraint and CEO Equity Grants

Abstract

We examine whether firms benchmark annual equity grants to compensation peers and whether meeting the participation constraint is a motive. Studying CEO equity grants over the period of 2006-2016 and compensation peers disclosed by the firm, we find that equity grants by these peers significantly determine a firm's equity grants. We find no evidence that the relation between a firm's and its peers' CEO equity grants is an indirect outcome of meeting peer total compensation levels. In contrast, we show that firms are more likely to meet peer equity grant levels when the labor market is more competitive and when losing key personnel is a risk factor. We also find that CEO turnover is more likely when the CEO receives lower equity grants than peers. Collectively, these findings are consistent with the theoretical prediction that benchmarking equity grants helps firms satisfy the participation constraint, which varies with performance.

Segment disaggregation and equity‐based pay contracts

“…The coefficients on Size and MTB are significantly positive, indicating that firms with higher market capitalization and growth options are likely to provide more equity incentives to their CEOs. The coefficient on Peer Grants is also significantly positive, consistent with firms tending to benchmark equity grants to their peers (Cadman et al, 2021).…”

“…Following prior studies (e.g., Cadman et al, 2021; Core et al, 1999, 2008; Smith & Watts, 1992), we also include a battery of firm characteristics to control for factors that may influence a firm's reporting decision with SFAS No. 131 and the provision of equity incentives, such as firm size ( Size ), the market‐to‐book ratio ( MTB ), leverage ( Lev ), stock volatility ( Vol ), stock returns ( Ret ), CEO share ownership ( Ownership ), whether or not the CEO is the firm's board chair ( Chair ), and whether or not the CEO is involved in an interlocking relationship ( Interlock ).…”

“…However, firms can award equity grants to managers for reasons other than incentive alignment, for example, to attract managers from CEO labor markets (e.g., Cadman et al, 2021; Edmans et al, 2023). Moreover, shareholders entrust their capital to managers and are willing to relinquish their decision rights over their assets because they believe that managers have better skills or knowledge for identifying investment opportunities (Jensen, 1998).…”

“…Therefore, given that equity-based incentives are costly (e.g., Core et al, 2003;Murphy, 1999), to the extent that implicit incentives allow firms to achieve the same level of desirable managerial actions, firms would reduce the provision of explicit incentives, such as equity-based pay contracts, when they disclose their segments in a more disaggregated manner. 1 On the other hand, however, firms can award equity grants to managers for reasons other than incentive alignment, for example, to attract managers from CEO labor markets (e.g., Cadman et al, 2021;Edmans et al, 2023). Moreover, shareholders entrust their capital to managers and are willing to cede their decision rights over their assets due to their limited business expertise (Jensen, 1998).…”

“…Understanding the extent to which the observability of managerial actions affects CEO pay contracts is important (Holmström, 1979(Holmström, , 1982, but to our knowledge, empirical evidence about this issue is scant in the literature. While the increase in the observability of internal capital allocations, as revealed through segment disaggregation, can decrease shareholders' demand for a provision of strong incentives to CEOs, firms could still rely on equity-based pay to retain managers by fairly measuring and recognizing managerial performance through stock price (e.g., Cadman et al, 2021;Edmans et al, 2023). Our findings suggest that the observability of managerial actions relates negatively to the provision of equity incentives, consistent with firms using equity-based pay contracts to address the unobservability of managerial actions (Holmström, 1979).…”