Compensation for Managers with Career Concerns: The Role of Stock Option in Optimal Contracts

Abstract

We study the problem of compensating a manager whose career concerns affect his investment strategy. We consider contracts that include cash, shares, and call options, focusing on the role of options in aligning incentives. We find that managers are optimally paid in cash, supplemented by a small amount of call options; shares are excluded. The options are struck at-the-money, consistent with the near uniform practice of compensation committees. The convexity of option payoffs helps to overcome managerial conservatism, though a non-trivial under-investment problem persists. Our model yields several testable implications regarding cross-sectional variation in the size of option grants and pay-for-performance sensitivity.

JEL Classification: G31, G34, J33, L22