Discussion paper

DP6515 Stock-Based Compensation and CEO (Dis)Incentives

Stock-based compensation is the standard solution to agency problems between shareholders and managers. In a dynamic rational expectations equilibrium model with asymmetric information we show that although stock-based compensation causes managers to work harder, it also induces them to hide any worsening of the firm?s investment opportunities by following largely sub-optimal investment policies. This problem is especially severe for growth firms, whose stock prices then become overvalued while managers hide the bad news to shareholders. We find that a firm-specific compensation package based on both stock and earnings performance instead induces a combination of high effort, truth revelation and optimal investments. The model produces numerous predictions that are consistent with the empirical evidence.


Veronesi, P, E Kandel and E Benmelech (2007), ‘DP6515 Stock-Based Compensation and CEO (Dis)Incentives‘, CEPR Discussion Paper No. 6515. CEPR Press, Paris & London. https://cepr.org/publications/dp6515