Benefits of Broad-Based Option Pay∗

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 payminimizes 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. ∗We thank Ken Ayotte, Ulf Axelson, George Baker, Jennifer Carpenter, Robert Gibbons, Paul Grout, Stijn van Nieuwerburgh, Paul Oyer, Canice Prendergast, David Webb, Luigi Zingales, and seminar participants at the University of Chicago, Columbia University, New York University, University of Virginia, London School of Economics, INSEAD, University of Bristol, and the Harvard-MIT Economics of Organizations workshop for helpful comments and suggestions. †INSEAD, London School of Economics, & CEPR. Address: Department of Finance, INSEAD, Boulevard de Constance, 77305 Fontainebleau Cedex, France. Email: [email protected]. ‡New York University & CEPR. Address: Department of Finance, Stern School of Business, New York University, 44 West Fourth Street, Suite 9-190, New York, NY 10012. Email: [email protected].