Economic Consequences of Equity Compensation Disclosure

In the paper Economic Consequences of Equity Compensation Disclosure, forthcoming in the Journal of Accounting, Auditing, and Finance, we develop a novel mechanism through which a principal may signal a firm’s type to outside investors. In our model, the principal does not need to retain any of the firm’s equity (unlike standard signaling models) but may competitively contract with a manager who is informed and may or may not provide effort.

We show that the choice of effort is affected by both the level of performance-pay chosen by the principal and the quality of the firm. If contracts convey information on the firm, then our analysis shows how and why a firm’s stock price and future operating performance should be associated to the choice of a particular pay package. In this respect, the model offers a framework to tie firm performance and contracting choices, in an optimal contract setting.

We further develop several predictions for future empirical applications. Even if information about a firm’s type is known to market participants, we show that pay-for-performance will be positively associated to the firm’s type and thus, also, to the agent’s effort and future earnings. In the model, the observed level of pay-for-performance is endogenous and the positive association of performance with incentive pay does not imply that greater firm value could be achieved by further increasing pay-for-performance. Examining reporting motives, we show that concerns for higher market prices can distort the optimal contract: namely, we show that when markets are more (less) responsive to information, such reporting motives lead to pronounced (muted) equity ownership, and higher (lower) pay and managerial effort. From a policy perspective, in these cases, mandated changes to compensation arrangements or their disclosure may potentially increase the efficiency of contracts.

The full paper is available for download here.