Member of the Department of Accounting Information and Management faculty between 2005 and 2008
It’s no secret that executives often sell substantial amounts of their equity holdings in their firm. This begs the question of how firms re-contract with executives after they sell these shares. Do firms simply replace the divested incentives? How does the change in executive wealth composition influence contract design? According to research by Kellogg School of Management Professor Brian Cadman, firms do not fully replenish shares divested from the firm. In addition, he finds that following executive equity sales that diversify executive wealth, firms increase the proportion of equity in annual compensation and target greater equity incentives.
Executives generally own substantial amounts of wealth in their firm. Shareholders and boards of directors encourage this ownership because it links executive wealth and returns to shareholders. To further enhance this link, large proportions of executive compensation are in the form of equity. While executive equity ownership provides incentives, it comes at a cost. One cost relates to project selection: to protect the value of their equity holdings, executives may avoid risky projects that well-diversified shareholders would prefer the firm to take. In addition, providing incentives and compensating managers with equity requires firms to compensate the executive for bearing the additional risk of equity as compared to secure payments that provide weaker or no incentives such as cash. With this in mind, an extensive stream of research predicts that firms balance the costs and benefits of equity compensation to provide the “optimal contract.”
When executives sell significant amounts of their firm’s equity, these equity sales can be substantial and dramatically change the composition of executive wealth. For example, in 2005 Kevin Rollins, the CEO of Dell Inc. exercised 993,000 stock options realizing a before-tax gain of more than $36 million. The effect of this transaction on incentives and how firms re-contract after executive equity divestitures is the focus Professor Cadman’s “Executive Equity Divestitures and Equity Granting Patterns” working paper.
Equity grants such as stock options and restricted stock account for a significant proportion of top executive compensation. Equity provides a stronger link between executive wealth and shareholders than other forms of compensation such as salary and bonus. Linking executive wealth to firm performance (pay-performance sensitivity) is an important element of executive contracting. However, for equity grants to provide incentives, it is important that the shares are non-tradable and executives are restricted from taking actions that hedge company stock price risk. These restrictions impose substantial risk on undiversified executives. The greater the proportion of executive wealth held in such restricted securities, the more they discount their value. Because these restrictions increase the cost of compensating executives, a compromise is generally achieved whereby selling restrictions on executive equity grants expire over some specified period (vesting period). Once these vesting periods expire, executives are generally afforded the opportunity to sell their equity holdings.
These equity divestitures can be large in value. From a sample of large U.S. firms in the S&P 500, Cadman finds that when the executives sell shares of their firm the average value is greater than $10 million. These equity sales transfer a substantial amount of wealth from their company’s stock to investments held outside the firm. Because a greater proportion of their wealth is held in other investments, their aversion towards firm-specific risk declines. At the same time, when executives sell their firms’ equity, they hold fewer incentives. As a result, it is not clear how firms should re-contract with executives following these equity divestitures.
From one perspective, as shown in figure 1, Cadman illustrates that the incentives (pay-performance sensitivity) provided by equity grants increase with the amount of executive wealth held outside the firm. This suggests that the cost to the firm of providing incentives (the amount of equity necessary to achieve desired incentives) declines with executive wealth diversification. At the same time, agency theory suggests that optimal incentives may increase with executive tolerance for firm-specific risk because the cost of providing incentives (imposing risk) declines.
Figure 1: Incentives provided by ten shares of equity over various amounts of wealth held outside the firm.
Cadman investigates compensation contracts in response to executive equity divestitures in a sample of over 1,500 firms spanning 1994–2004. He finds that firms increase equity grants to replenish the incentives divested from the firm. However, his evidence suggests that “firms do not fully replace the incentives divested from the firm.” He notes that “this may occur because it is either too costly for the firm to replenish divested incentives, or because executives divest equity when their incentive portfolio is above optimal levels.”
To distinguish between these two explanations, Cadman then investigates how the increase in executive wealth diversification from executive equity divestitures influence incentives targeted by new equity grants. He finds a positive relation between the incentives targeted by new equity grants and an increase in executive wealth diversification. These findings suggest that targeted equity incentives increase with executive wealth diversification. Cadman explains, “When contracting with an executive that is more diversified, the data suggests that firms respond by increasing the level of incentives.” He further comments that “this is consistent with predictions in prior work that risk aversion and wealth diversification play a significant role in contract design.”
So what happens to the other elements of compensation? Cadman finds that after controlling for grants in response to deviations from predicted incentives, the proportion of annual compensation in the form of equity increases with executive equity divestitures. That is, the executive compensation contract shifts towards equity. “This shift towards equity pay following a divestiture is, in part, a response to replenish the shares divested by the executive. The interesting component,” notes Cadman, “is that after controlling for grants to replenish divested equity, firms appear to grant a greater proportion of compensation in equity.”
Overall, the findings are consistent with firms adjusting contracting schemes in response to an increase in executive wealth diversification. Specifically, the findings suggest that firms increase targeted incentives; in addition, firms increase annual compensation in the form of equity. Together the findings provide evidence that firms consider executive wealth diversification in contract design and target risk-adjusted equity incentives from the executive perspective. These results are consistent with the hypothesis that the marginal cost to the firm of providing incentives declines with executive wealth diversification. More generally, Cadman presents evidence indicating that executive wealth diversification significantly impacts optimal contract design.
The conclusion? It is not so clear how firms re-contract when executive sell their firms equity. On average, firms do not replace divested shares. However, firms increase the proportion of annual compensation in the form of equity and target greater incentives. Maybe it is not so bad when executives sell. Cadman’s research suggests it might just reduce the costs of contracting and providing incentives to CEOs.
Rafael Rogo is a doctoral student in Accounting Information and Management, Kellogg School of Management, Northwestern University.
Cadman, Brian D. 2008. “Executive Equity Divestitures and Equity Granting Patterns.” Working Paper, Kellogg School of Management.
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