Executive compensation and the investment opportunity sets of initial public offerings

This study examines how the components of CEO compensation contracts vary with characteristics of initial public offering firms (IPOs). There are two major steps in the analysis. The first step investigates whether IPOs exhibit variation in characteristics that theory predicts affect compensation contracts. The second step investigates whether these differences across firms are related to the use of accounting versus non-accounting performance evaluation measures, levels of base salary and cash bonuses, and the value of stock options for CEOs. Results from this study support the importance of modeling compensation components separately. Theoretical constructs differ depending on the type of compensation being explained. This separation allows more powerful inferences than are possible in studies that combine the components.; The use of accounting earnings in incentive compensation contracts has been well documented for large firms. Accounting numbers are useful when they signal the value added by the manager. For IPOs that are creating or exercising growth options by investment in research and development or advertising, accounting numbers may be less informative, which leads to a substitution of stock-based incentives for income-based incentives. This is the first study to examine the relative importance of accounting-based compensation for firms that are going public. For the analyses, IPOs are classified by the observable characteristics of their investment opportunity sets (IOS). This includes an examination of the relations among growth, ex ante risk, and ex post risk. Cross-sectional variation in IOS measures such as size, growth, risk, and firm performance are supported by the data and this variation partly explains cross-sectional differences in compensation contracts. Results from tests that include CEO characteristics and equity ownership are clearly inconsistent with CEO opportunism. Also, the results are generally consistent with efficient contracting.