DP4878 Benefits of Broad-based Option Pay

Author(s): Roman Inderst, Holger M Mueller
Publication Date: January 2005
Keyword(s): Broad Option Pay, Employee Stock Options
JEL(s): J31, J33
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4878

Future wage payments drive a wedge between total firm output and the output share received by the firm?s owners, thus potentially distorting strategic decisions by the firm?s owners such as, e.g., whether to continue the firm, sell it, or shut it down. Using an optimal contracting approach, we show that the unique optimal firm-wide employee compensation scheme from this perspective is a broad-based option plan. Broad-based option pay minimizes the firm?s expected future wage payments in states of nature where the firm is only marginally profitable, thus making continuation as attractive as possible in precisely those states of nature where, e.g., a high fixed wage would lead the firm?s owners to inefficiently exit.