On The Equity Incentive Motivation, Cost And Risk

Stock-based compensation, which grants the executives either stocks or the right to buy a share of stock at a pre-specified exercise price for a pre-specified term, is thought as a method to align the interests of executives and shareholders. To some extend, it gives the executives the same right as shareholders in decision-making as well as profit and risk sharing. With these regards, stock-based compensation is usually taken to offer the executives incentive to work for the long-term development of the firm. In China, it also raises more and more attention. By May 2008, Chinese listed companies have announced 122 plans of stock-based compensation, which gives us the opportunity to conduct the empirical studies. Based on a binary selection model and correlation analysis, we discuss the impact of eight firm characteristics on the occurrence probability and strength of those stock-based compensation plans. According to the results, we find that there are three significant factors, namely, industry regularity, alignment of executive wealth and stockholder returns, growth opportunity of the firm, and the fraction of stocks held by institution investor. Furthermore, executives are different from outside stockholders in the perspective that their assets are less diversified, which make them under-valuate their firm stocks. To further illustrate this idea, we calculate the efficiency of those plans with a model introduced by Lisa K. Meulbroek (2000). It's showed that the average efficiency ratio for stock compensation is 0.83, and for option compensation it is 0.79. What's more, we also discuss the different risk effects of stock compensation and option compensation. Through the analysis of a Principal-agent model, we find that the volatility of stock returns is negatively related to the amount of stock granted in stock-based compensation. In addition, an inspection of the B-S model tells us that, the volatility of its return does not affect the value of stock, but can enhance the option value if it increases. If he is granted with option compensation, the executive will have some specific risk preference over project selection to increase his option value.