Waddell, Glen R.

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Work hard, not smart : stock options as compensation
(University of Oregon, Dept. of Economics, 2003-06-01) Barron, John M.; Waddell, Glen R.
This paper examines the optimal compensation package for executives, in particular the optimal mix of stock options and stock grants, for an agent deciding whether to adopt or reject a plan of uncertain value. The compensation structure in such a setting affects not only an executive's efforts to improve the precision of signals regarding the true value of proposed plans but also the choice of a reservation signal that determines the likelihood a proposed plan is adopted. While stock options can bias an executive’s decision criteria away from first-best, we show that the leverage they provide to motivate an executive to undertake more extensive plan evaluation makes options the preferred form of equity compensation if the exercise price is freely chosen. However, there is a role for restricted stock in realigning the interests of the executive with shareholders if the firm is constrained in the choice of the exercise price, which we argue may sometimes be the case. Using extensive data on top-executive compensation, we report evidence on this tradeoff that is consistent with the theoretical predictions. We also find that the extent of option compensation among top executives at a firm is associated with an increase in the likelihood of extreme returns in subsequent periods.