An Analysis of Net-Outcome Contracting with Applications to Equity-Based Compensation

45 Pages Posted: 8 Aug 2017 Last revised: 21 Jun 2018

See all articles by Christian Hofmann

Christian Hofmann

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management)

Steven J. Huddart

Pennsylvania State University, University Park - Department of Accounting

Thomas Pfeiffer

University of Vienna - Accounting and Control

Date Written: June 6, 2018

Abstract

Given a standard moral hazard problem, the agent’s optimal compensation can be cast as a function of either (i) the gross outcome, or (ii) the net outcome, which is the gross outcome net of the agent’s compensation. Contracts based on the net outcome are important in practice because (i) equity-based compensation (e.g., stock and options grants, and bonuses contingent on shareholder return) is pervasive and (ii) stock price is firm value net of compensation. We characterize the optimal net-outcome contract in terms of its slope, curvature, complexity, and pay-for-performance sensitivities. We further describe limitations of net-outcome contracting. We trace implications for research that has examined equity-based compensation through the lens of gross-outcome contracting.

Keywords: dilution, equity-based compensation, moral hazard, optimal contracting, pay-for-performance sensitivity, stock options

JEL Classification: D86, J33, M41

Suggested Citation

Hofmann, Christian and Huddart, Steven J. and Pfeiffer, Thomas, An Analysis of Net-Outcome Contracting with Applications to Equity-Based Compensation (June 6, 2018). Available at SSRN: https://ssrn.com/abstract=3014149 or http://dx.doi.org/10.2139/ssrn.3014149

Christian Hofmann

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management) ( email )

Kaulbachstr. 45
Munich, DE 80539
Germany

Steven J. Huddart (Contact Author)

Pennsylvania State University, University Park - Department of Accounting ( email )

University Park, PA 16802-3603
United States
814-863-0448 (Phone)

HOME PAGE: http://directory.smeal.psu.edu/sjh11

Thomas Pfeiffer

University of Vienna - Accounting and Control ( email )

Bruenner Strasse 72
Vienna 1210, Vienna
Austria
+43-1-4277-38002 (Phone)
+43-1-4277-38004 (Fax)

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