Disentangling managerial incentives from a dynamic perspective: the role of stock grants
We
analyze the optimal contract between a risk-averse manager and the initial
shareholders in a two-period model where the manager’s investment effort,
carried out in period 1, and her current effort, carried out in period 2, both
impact the second-period profit, so that it may be difficult to disentangle the
incentives for these two types of effort. The contract stipulates (a) the
profit-contingent cash remunerations for each period, (b) the number of shares
that will be granted to the manager at the end of the first period, and (c) the
restrictions (if any) on the sale of the granted stock. We show that the stock
grants play different roles according to whether the signal of investment
effort is less noisy, or noisier, than that of current effort. In the former
case, at the optimal solution the firm gives more incentive to investment
effort than to period 2 current effort, and there is no need to restrict the
sale of granted stocks: the stock grants serve as an incentive device for
investment effort, and it is efficient to permit the manager to sell all her
shares to eliminate her dividend risk. In the latter case, the efficient
contract does not allow the manager to sell all her granted stock, and both
current and investment efforts are given the same incentive. In this case,
stock grants play a different role: they serve as commitment device to overcome
the time-inconsistency problem. We determine simultaneously the optimal stock
grants and the optimal restrictions on sales of shares.
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