The Executive Equity-Based Incentives: Theory And Effects

One of the most important characteristics of the institution of modern firm is the separation of ownership and Control. The executives employed by their employers obviously own more information. The asymmetry of information with inconsistency of objective functions makes the executives shift away from their principal's goal, thus leading to the agency problems of adverse selection and moral hazard. The modern theory of firm suggests we mitigate the agent problems by establishing an effective allocative mechanism of residual claims and control. Represented by executive stock option, the equity-based incentives just meet the case and can be applied to remuneration package fairly well. Based on agency theory, this essay analyzes the superiority of equity-based incentives, representative of ESO, over traditional compensation package; points out the advantage of distinctive risk-taking incentives of ESO versus its counterpart, the stock-based compensation; syncretizes the perspective of game theory and human capital theory to explain ESO, adding to the ESO's theoretical foundation; summarizes the empirical evidences supporting the ESO's incentives effects.However, in the wake of recent financial scandals around the world, much of the blame has been directed to executive compensation and stock option in particular. Aiming at various critiques on ESO, we do much rethinking and find that most of the blame in essence is not so much on ESO, but on broader issues of corporate governance, outside regulation, information revelation and so on. Financial scandals should not be attributed to ESO, other equity-based compensation such as restricted stock could induce financial fraud as well, just to a different degree at all. Using a simple, but general principal-agent model with moral hazard, we have compared option-based contracts with stock-based contracts. A conclusion is drawn that option-based contracts generally dominates stock-based contracts. Outright abandoning ESO is not warranted.In the forth part of the essay, we analyze the possible problems of equity-based compensation and find that ignorance of cost of capital can get the executivesexcessively paid even when the firm's value is ruined. We thus suggest a cost of capital adjusted option (EVA stock option) and analyze its advantage of self-select and screening effects.Within the last section, we discuss several constraints under which stock option incentives can not be effectively applied to our country. We having absorbed the US experiences and analyzed the problems encountered when ESO is implemented at home and abroad, a conclusion is finally reached: the EVA-based stock option or EVA-based phantom stock option can be implemented appropriately in our country.