The Temporal Structure of Equity Compensation∗ (Preliminary Version)

It is well accepted that aligning managerial incentives with those of stock holders enhances shareholder value. In theory models, such alignment is usually modeled as giving managers a stake in the realized cash flows of the firm’s projects. However, such a stake, which entails a manager holding on to her equity position until all cash flow uncertainty is resolved, can lead a risk averse manager to turn down risky positive NPV projects. In this paper, we argue that equity-linked incentives can mitigate the manager’s bias against assuming risk, provided the manager is allowed the flexibility of trading out her equity position early. Thus, allowing managers to hedge away partially the risks associated with their firm’s stock price may actually be in the shareholders’ best interests. However, it can lead to excessive risk-taking when the firm has debt in its capital structure.