Compensation as a governance mechanism

Incentive contract

Manager is paid according to their actual effort

If managerial effort is unobserved what happens?

Firm performance can be used as a crude proxy of managerial effort. When the firm does well (net of industry effect, business cycle, etc.) the manager has done a good job. If the manager invests in wasteful projects, the company will underperform. Working under the assumption that managerial effort and firm performance are correlated, i.e. the harder the manager works, the better firm performance.

CEO sudden death

Either there is no effect on company performance because the CEO does not matter

Or the CEO matters but is easily replaceable and there is no effect

CEO effect on profitability

How much a CEO works is an optimisation problem

Firm performance can be used if you filter out the effect of other factors

You pay in a certain way, wanting to optimise…

firm performance and managerial effort

Long-term incentives pay

CEO given shares, value of shares linked to firm performance and thus managerial effort.

Want to maximise long-term performance rather than short-term. This is not done via salary, annual bonuses, but by long-term incentive pay like equity awards.

How do equity awards maximise long-term performance?

There is an investing period so that the equity shares are actually awarded to the CEOs after a certain time period. This links the value of the company with the CEO action for long-term performance.

Cycle of aligning owner-manager incentives through executive compensation

Executives receive incentive-based pay

Executives work hard

Company’s results improve

Stock price increases

this increase incentive-based pay

Prediction between CEO pay and firm performance

You would expect them to have a strong positive correlation but this is not the case in reality

Efficient contracting view

CEOs are rare, and outside options for them have increased enormously

Larger firms are in constant search for the right manager: higher return on managerial skills

High CEO pay can reflect firms competing for scarce managerial talent: paying more can be worthwhile if the right CEO creates enough value.

Managerial power view

CEOs have been found to be paid for luck, e.g. an increase in pay due to increase in performance, such as oil price, which is not attributable to them

Entrenched managers set the pay package for themselves

High CEO pay can result from CEOs’ influence over the board, allowing them to obtain pay that benefits themselves rather than shareholders.

Minimum share ownership - regulatory protection for shareholders

Minimum share of ownership to call for extraordinary shareholder meetings (lower the minimum = more protection for shareholders)

Proxy vote - regulatory protection for shareholders

Makes it easier for shareholders to vote

Direct representation on the board - regulatory protection for shareholders

Protects minority shareholders by helping them elect directors who represent their interests and can monitor management and controlling shareholders.

Presence of judicial venue to challenge the management - protection for shareholders

Shareholders can take management’s actions to court if they believe those actions violate their rights or managers’ duties.

Preemptive rights in equity issuances - regulatory protection for shareholders

Giving the right to shareholders to buy the shares beforehand - being more shareholder friendly

This protects shareholders against dilution of their ownership and voting power. However, you must pay for the new shares to maintain your stake—the right does not give them to you for free.

Investor activism

when investors actively use their ownership stake to influence how a company is managed.

blockholder investor activism

block holders who sell a firm’s stock based on private information impose toward pressure on prices

this effect hurts management through its equity investment in the firm

management increases productive effort to increase firm value and dissuade block holders from selling

does the governance mechanism that block holder use come from selling?

no, only from the threat of block holder exit

What is a corporate governance mechanism?

A system of internal and external controls used to direct business operations and protect stakeholder interests.

What is needed for threat of block holder exit to be credible?

Stock should be highly liquid

What does competition do to firms?

Forces firms to minimise costs, inefficient firms due to lazy management will not survive in the long-run.

How does bad management affect asset price?

Price of asset is lower than its potential. If management is bad in a competitive market, you will be taken over.

Takeover mechanism

Managerial inefficiency is detrimental to market value

A bidder makes an offer the the shareholders of the firm

Acquires control

Takeovers are often regulated by?

Laws and firms who introduce legal obstacles to decrease the likelihood of being acquired

How do family firms change responsibilities?

Leads to an overlap of roles rather than a separation, the board, shareholders, and to management overlap. There is no more separation between ownership and control.

What do family boards have better in terms of management control?

Better coordinate to monitor the management - lowering the risk of free-riding

Ownership and control family firms

Often owners are themselves the managers of the firm - no separation

Nepotism in family firms

Is management optimised?

What is free riding?

Occurs when an individual employee, a team member, or another company benefits from shared resources, group efforts, or investments without contributing their fair share of time, money, or work.

How do family firms reduce the risk of free riding?

Concentrated family ownership and shared identity align the personal interests of managers and owners, making self-serving behaviour more visible and costly to the family’s shred financial wealth.

Agency problems in family firms

related party transaction and minority versus majority investors

Related party transaction - agency problems in family firms

Favouring family-owned external vendors with inflated pricing

Or selling to a family-owned external buyer at a value below market price

Minority versus Majority investors

Controlling families possess the voting power to bypass minority interests

Executive compensation - minority exploitation

• Appointing unqualified family members to high-salaried executive roles.

Strategic entrenchment - minority exploitation

Hoarding cash or avoiding dividends to starve minority returns

Dual-Class shares - minority exploitation

• Separating voting rights from cash-flow rights to maintain absolute control with minimal capital.

Is executive compensation necessary?

Yes, it is a necessary incentive for top executives to manage the corporation