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An analysis of net-outcome contracting with applications to equity-based compensation

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  • Christian Hofmann

    (Ludwig-Maximilians-Universität München, LMU Munich School of Management)

  • Steven Huddart

    (Penn State, Smeal College of Business)

  • Thomas Pfeiffer

    (University of Vienna)

Abstract

Options, restricted stock, bonuses tied to total shareholder return, and similar equity-based compensation contracts stipulate payments that depend on stock price. Any such contract is a function of shareholder value net of the compensation payment, because stock price (1) is proportional to this net value or “net outcome” and (2) anticipates compensation-related payments and dilution. The net outcome, in turn, is reduced by the payment and so depends on the contract. Standard moral hazard analyses, wherein contractual payments are based on the gross outcome before any payment to the agent, overlook this dependency. We characterize the optimal net-outcome contract, describe its shape and pay-for-performance sensitivity, contrast it with the optimal gross-outcome contract, and discuss implications for equity-based compensation arrangements.

Suggested Citation

  • Christian Hofmann & Steven Huddart & Thomas Pfeiffer, 2023. "An analysis of net-outcome contracting with applications to equity-based compensation," Review of Accounting Studies, Springer, vol. 28(3), pages 1657-1689, September.
    • Handle: RePEc:spr:reaccs:v:28:y:2023:i:3:d:10.1007_s11142-021-09666-w
    DOI: 10.1007/s11142-021-09666-w
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    References listed on IDEAS

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    More about this item

    Keywords

    Dilution; Moral hazard; Team compensation; Optimal contracting; Pay-for-performance sensitivity; Stock option;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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