Michael L. Lemmon
James J.D. Wang
Fuqua School of Business, Duke University, Durham, NC 27708
Abstract
In this paper we examine the use of stock-based compensation as an efficient mechanism for aligning the interests of management with those of shareholders. We identify a benefit of stock-based compensation that can help to reconcile the apparent incongruity between the theoretical predictions regarding the inefficiencies of compensation based on the firm's stock price and the observed empirical regularity regarding the frequent use of compensation tied directly to the firm's stock performance. In our model, the benefits of stock-based compensation arise from the market's ability to monitor the actions of the manager in a manner that favorably alters the resolution of the moral hazard problem. Intuitively, the market aggregates nonverifiable information into an objective and verifiable performance measure-the form's stock price. The costs of stock- based compensation arise from its limited dimensionality. That is, the stock price is a single number that reflects only the total value of the firm's individual projects. We show that the benefits of stock-based compensation tend to be large when (i) the payoffs to a t least one of the firm's projects is measured poorly; (ii) the ability of the market to monitor managerial actions is high; and (iii) the ability of the market to monitor managerial actions is high. In addition, our model generates predications about the relation between underlying firm characteristics and the use of stock-based compensation. The predictions of our model are generally consistent with the existing empirical evidence.