Share Repurchases, Equity Issuances, and the Optimal Design of Executive Pay

Jesse Fried is a Professor of Law at Harvard Law School.

Academics, regulators, and investors have been urging firms to tie executive pay to the long-term stock price. In the paper, Share Repurchases, Equity Issuances, and the Optimal Design of Executive Pay, which was recently made publicly available on SSRN, I explain why tying executive pay to the future value of the firm’s stock—even the stock’s long-term value—can sometimes perversely reward executives for taking steps that reduce the value flowing from the firm to its public investors over time.

The paper describes and analyzes two distortions caused by tying an executive’s payoff to a stock’s future value. The first is “costly contraction:” when the stock’s current price is below its actual value, the executive may have an incentive to divert cash from productive projects in the firm to fund bargain-price share repurchases. If the stock trades for a low enough price, a bargain-price repurchase can boost the value of the executive’s shares even if the repurchase forces the firm to cut back on profitable investments.

The second distortion is “costly expansion:” when the stock’s current price is higher than its actual value, the executive can boost his long-term payout by causing the firm to issue new shares even if the firm cannot productively deploy the cash or other assets it receives in exchange. If the stock trades for a high enough price, the inflated-price issuance can boost the value of the executive’s shares even if the investments facilitated by the issuance are negative expected value. The general problem is that an executive holding stock is encouraged to consider the firm’s current stock price in making firm-size decisions rather than making these decisions solely on economic value considerations.

The paper also puts forward a mechanism that would eliminate executives’ incentives to repurchase stock merely because it is cheap and issue stock merely because it is overpriced: the “constant-share” approach. Under this approach, an executive would be required to adjust her equity holdings in the firm whenever the firm purchases or sells its own shares to keep her percentage ownership constant through the transaction. Thus, the executive would be required to sell some of her shares whenever the firm repurchases its own stock and to buy additional shares when the firm issues new equity. I explain how the constant-share approach would encourage executives to contract and expand the firm only when doing so increases the value flowing to its investors over time.

The full paper is available for download here.

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