Incentive problems and the structure of executive compensation: Theoretical and empirical evidence

Empirical studies on compensation schemes indicate that stock prices react positively to the introduction of performance-based compensations. The reason given for this positive reaction is that a performance-based component would induce the manager to reduce perk consumption. The argument is presumably based on agency explanations of Jensen and Meckling (1976). In their seminal article on agency theory, Jensen and Meckling (1976) show that agency problems between stockholders and manager arise when the manager decides to raise outside equity capital. They also show that the value of the firm would decrease as the proportion of management equity ownership decreases. It is assumed, therefore, in the compensation Uteramre that the value of the firm would increase as the performance-based component increases. However, it is quite possible that when the manager's performance-based compensation increases, his equity ownership in the firm may not simidtaneoush increase. As an example, if the performance-based compensation is in the form of stock appreciation rights, where the compensation depends on the market value of shares but is given in the form of cash, the manager's equity' ownership need not increase. A theoretical explanation for the positive reaction of the stock market to the adoption of performance-based compensation schemes, holding the equity ownership of the manager constant, however, has not been attempted so far.