The relationship between equity incentives for C-level executives and company performance has received enormous attention due to the cost to shareholders of the compensation awarded to top executives. An often neglected — but potentially more important — question is whether equity incentives influence executives’ risk-taking in ways that are detrimental to the company.
In a recent study, we undertook an in-depth analysis of the relationship between CEO equity incentives and strategic risk decisions in the life sciences sector, a sector in which executives typically receive a higher proportion of their compensation in equity incentives. This study offers unique insights to boards and the board subcommittees tasked with executive compensation and risk management. Most notably, we find that the equity incentives held by CEOs may induce bias in their recommendations with respect to major strategic decisions. To counter this bias, boards need to consider, in tandem, both the mix of equity incentives and the level of risk inherent in the decision.
Stock Versus Options Is an Important Distinction
In our research, we looked at the effects of the two major equity incentives offered to C-level executives: options to buy company shares at a set price (aka options) and outright share ownership (aka stock).
Awarding options often encourages risk-taking. Think about it this way: If a company’s stock price is languishing far below the price at which options can be exercised, an executive is more likely to pursue a high-risk strategy. From the executive’s perspective, if the strategy succeeds, the stock price soars, along with the value of said options. If the strategy fails, the executive’s options simply remain as worthless as they were before. While this may encourage aggressive risk-taking, the potential collateral damage for the organization can be high.
In direct contrast to options, the payoffs from the second major equity incentive, stock, are inherently tied to both increases and decreases in the company’s stock price. Executives with a large amount of stock naturally become more concerned about the potential downsides of risk-taking. Without the one-way-bet mentality encouraged by options, executives become more risk averse as they seek to protect their wealth.