Six Challenges in Designing Equity-Based Pay

Abstract

This paper analyzes why the primary goal of the equity-pay explosion--creating long-run ownership incentives for top executives--has often been difficult to achieve in practice. More generally, I describe six challenges in the design of equity-based pay plans and discuss potential solutions. The six challenges involve: 1. mismatched time horizons; 2. gaming; 3. the value-cost wedge'; 4. the leverage-fragility tradeoff; 5. aligning risk-taking incentives; and 6. avoiding excessive compensation. The paper also discussed the merits of stock versus options and concludes that restricted stock is often a superior form of compensation.