Bachelor thesis: Equity-based managerial compensation: agency solution or problem

Transcription

1 Bachelor thesis: Equity-based managerial compensation: agency solution or problem Jordi van Eck S bedrijfseconomie Supervisor: Dhr. P.Geiler Coordinator: Dhr. J.Grazell

2 Index: Chapter 1: Introduction Chapter 2: Literary review and hypotheses : The agency problem Compensation structure Optimal contracting Managerial power Pay for performance relation Hypotheses Chapter 3: Data and methodology: Performance measures Independent variables Control variables Empirical model Chapter 4: Empirical results Chapter 5: Conclusion and recommendations

3 Chapter 1: Introduction Nay on pay, America s shareholders find a voice to condemn undeserved compensation. This was the headline of an article in The Economist on 13 th of May In one week time shareholders of two big US companies voted against the pay of a CEO. First the shareholders of Motorola, four days later the shareholders of Occidental Petroleum. The shareholders voted against this pay because in their opinion the CEO incentives were not in the best interest of the shareholders. These different incentives are an example of the agency problem between CEO s and shareholders (Jensen and Meckling, 1976) A way to align interests of shareholders with CEO s is by linking compensations to firm performance, the so called pay for performance relation. In the contract of a manager, a compensation standard is set, which a manager receives when he reaches a set of performance targets defined in their contract. The shareholders determine these performance targets. These targets are related to firm performance, so managers are encouraged to make decisions creating as much firm value as possible. In literature this has been seen as a (partly) solution to the agency problem between managers and shareholders, the so called optimal contract approach (Bebchuk and Fried 2003). But managerial compensation can also be seen as part of the agency problem. Researches about the managerial power approach (Bebchuk and Fried 2004) or rent extraction (Chalmers, Koh, Stapledon, 2006) are examples in which the manager does not put firm performance is his first priority, the manager is rather looking to maximize his own benefit by influencing his own pay. According to these approaches power of the manager is an important factor. Managers with a lot of power are looking for compensation in ways that are not necessarily consistent with firm performance. In this way compensation does not solve the agency problem, but may even make the problem worse because the manager may have incentives to get compensation while company performance is not increasing. So the question is whether compensation is linked to firm performance or not; to see if equitybased compensation is really linked to performance or if compensation makes the agency

4 problem worse. For US firms in the period research showed compensation in general made the agency problem worse, which also had to do with the board and ownership structure which encouraged the manager to more rent extraction (so compensation not linked to performance) and as a consequence the firms which had to deal with a bigger agency problem, performed less (Core, Holthausen, Larcker, 2003). Other research not focussing specific on equity-based suggests that the pay for performance relation can be positive for CEO s. According to Hall and Liebman(2003) a manager is more focussing on company performance when stock-based compensation is involved. These results are consistent with results from Mehran (1995) who found a positive pay for performance relation when stock compensation is involved. Also stock possession of a CEO can influence the pay for performance, the research of Jensen and Murphy (1990) confirms stock possession of CEO s enlarges thee pay for performance relation.. So the focus of this research will be on equity-based compensation because the prior mentioned researches suggests this has the strongest pay for performance relation. It is important to see if this believe still holds some ground after all the compensation criticism (like the managerial power approach) and the researches who found no pay for performance relationship. So this research can also lead to the prove that this criticism is not justified and that compensation pay-offs in the form of equity are the best possible solution of the agency conflict. The outline of this research is as follows. In chapter 2 a literary review is given, which leads to the hypotheses of this research. In chapter 3 the methodology will be explained; the performance measures, the equity-based compensation components and the empirical model. Chapter 4 provides the empirical results and Chapter 5 the conclusion and the recommendations for further research. Therefore the main question of this research is: Is equity-based managerial compensation a solution of the agency problem by looking at the pay for performance relationship? The results of this research is that equity-based managerial compensation is a (partly) solution to the agency problem, because of a positive pay for performance relation between compensation and the performance measures ROA and Tobin s Q. But there are several more researches needed because of other influences on this pay for performance relation like the board structure of a firm, macro-economic influences like inflation and accounting manipulation of the performance measures.

5 Chapter 2: Literature review and hypotheses 2.1 The agency problem It was already noticed before the Second World War in 1932 by Berle and Means that managers and shareholders can have very different incentives. This theory later advanced into the agency theory (Jensen and Meckling, 1976). In general the agency theory states there is a relation between a principal and an agent. In this relation the agent is hired to perform some service in the best interest of the principal. This involves delegating the agent some decision authority. This agency relation is not perfect because both principal(s) and the agent have different incentives and different welfare maximization. These differences in incentives can cause problems for the principal, because their welfare in some setting may not be optimal. Agency relations occur in many settings, like in this research the manager and shareholder relation. All agency relation problems have the same basis; there is an information asymmetry between the two parties. In general this information asymmetry can be solved by monitoring, so controlling on the initiative of the principals which is a costly solution. Or by bonding, a controlling initiative by the agents, also a costly solution with is further explained in section Shareholders are the principal(s) hiring a manager, the agent, to lead the organisation. Managers are meant to be working in the best interest of the shareholders, with the main incentive to maximize shareholder value. But the manager is rational and finds his own incentives more important. Shareholders do not have access to all decisions made by the manager because of the information asymmetry (Jensen and Meckling, 1976). This asymmetry contributes to behavioural problems of managers like on the job consumption. The manager might consume several expensive luxury goods without the shareholders even knowing. Another example of exploiting this asymmetry is empire building (Jensen, 1986). In this phenomenon managers try to create an empire by growing the resources under their control, causing the firm to grow above the optimal size (Jensen, 1986). According to Jensen managers try to grow the dollar value of assets under their control, by merging and acquiring for example other firms. Managers use cash flows available to finance this behaviour, instead

6 of thinking about shareholder wealth (Jensen, 1986). This kind of behaviour also contributes to decrease the operating performance which also reduces firm value because of the costs associated with this behaviour. According to Jensen (1986) the manager behaves this way to influence the measurement of performance for a managers compensation, so how a manager s compensation is related to the firm performance measurement. Jensen (1986) gives the example if a manager s performance is linked to product sales it will encourage the manager to expand his current firm with other firms. This is exploiting the number of products produced (and so the sales) beyond the optimal level because it will boost the number of sales without looking at the costs associated. Another reason for a manager to acquire or merge with another firm is to find a justification for his compensation (Bebchuk and Fried,2003). Bebchuk and Fried (2003) point out when a firm has poor results and so the compensation for a manager is not justified by the results, a manager can point out the growing of the firm to get his pay. The agency problem between managers and shareholders can also occur in the situations in which the manager has to decide to adapt a certain positive NPV project and he makes the wrong decision by rejecting a project with a positive NPV. This is because managers are being risk-averse (Harris and Raviv, 1979). Shareholders are not risk averse because shareholders can diversify their risk in their stock portfolios (Eisenhardt, 1985). This difference in attitude towards risk can enlarge the agency problem, because it creates different incentives between the manager and the shareholder (Smith & Stulz, 1985). Smith and Stulz (1985) give the example in which a manager would reject a certain positive NPV project, while the shareholders are willing to take the risk. According to Harris and Raviv(1979) this risk aversion of a manager also implies a manager will prefer a structured way of compensation to minimize his personal risk, with the consequence a manager will prefer fixed pay compensation over equity-based compensation But from a shareholder perspective, this difference in incentives by managers and shareholders are minimalized when their compensation is linked to firm performance. A manager will be making decisions considering to maximize firm value (Grossman and Hart, 1983) Agency costs There are 3 type of costs incurred to these information asymmetry problems (Jensen and Meckling, 1976). First of all according to Jensen and Meckling (1976) there are monitoring

7 agency costs, costs from a control incentive by the shareholders. With monitoring, a principal like the shareholders get inside information from the company to see the decision making of a manager. As a consequence the principal can interfere when he is not content about a decision of the agent. But often this controlling is not possible for the full 100% because shareholders do not have the ability to monitor every decision of the manager and it is a costly solution (a reason why optimal contracting is important, explained in section 2.3). Another agency cost according to Jensen and Meckling(1976) is bonding, cost incurred from a control incentive by the manager. Like with monitoring these costs are incurred by the company to decrease the information asymmetry. Bonding is like monitoring, but with the difference that bonding is an initiative from the manager. According to Jensen and Meckling (1976) the manager can have several reasons to imply bonding, for example it can give more job security because shareholders have more insight into the work process of a manager. It also contributes to a better reputation for future job possibilities. Just like monitoring it does not solve the agency problem entirely and it is very costly, but it can give positive signals to outsiders of the company for example giving positive signals to some possible capital suppliers. The third type of costs incurred are the so called residual loss. Jensen and Meckling (1976) call this the dollar equivalent of the reduction in welfare experienced by the principal. In other words the overall lost suffered by a shareholder. 2.2 Compensation structure Another control incentive, the optimal contract is the focus of this research which aims to link the compensation of a manager to firm performance. First of all it is the fixed compensation, primary the base salary. According to Kerin (2003) this is not directly depending on firm performance, but is a fixed cash amount most of the time based on the standards of an industry (so in comparison with other firms in the same industry). According to Kerin (2003) there are not only cash compensations that are fixed, but also non- financial compensations like a car for personal use, the so called fringe benefits. Of course salary can change over time, a CEO can receive a higher or lower salary over time because it is reviewed once a year. While it is likely a performing CEO will receive a higher base salary in the future, which is determined looking at last year s performance, research has proved there is no strong link between firm performance and salary (Hall and Liebman, 2003). According to Hall and Liebman this weak link is because salary is not adjust when a firm is underperforming, it only adjusts upwards when a firm is performing.

8 2.2.2 Variable compensations Next to the base pay, managerial compensation can take many forms (Jensen and Murhpy, 1990). First of all there is the cash bonus. According to Jensen and Murhpy (1990) this cash bonus is a variable sum of money a CEO gets above his fixed salary, if he meets the targets of the shareholders. So the pay of this manager is supposed to be linked to the performance of the firm. However just like the salary, the cash compensation is public information, so it is open to third parties (next to the CEO and the companies) for criticism. According to Jensen and Murphy (1990) these third parties like employees, labour unions, consumer groups, and the media create a force against these compensations because of the believe it is not linked to performance, for example when a company had a declined share value. Jensen and Murphy (1990) conclude this political interference is one of the reasons why total compensation has decreased for the period This cash compensation is determined on an annual basis looking at the results of a company in that particular year, most of the time determined with budgets (Jensen and Murhpy, 1990). These budgets can be based on industry standards, compensation schemes of the past or even sometime be negotiated when a managers signs a contract at a particular firm. Jut just like with the base salary, there is weak link between cash pay and performance (Hall and Liebman, 2003). The reason Hall and Liebman (2003) find is the same as with the salary, cash bonuses are not adjusted when a company is performing poorly. Other compensation according to Jensen and Murphy (1990) can also include long-term incentives plans. These are not paid annually but based on some longer period of time. The long-term incentive plans are to encourage shareholder value creation, to link the interest of a CEO with those of shareholders. So if over a period of time a CEO has created more shareholder value, the CEO is rewarded with an extra bonus. In this way a CEO is encouraged to work for a company for a longer period of time. The most important type of compensation (the focus of this research) is the equity-based compensation. There has been research and theory about equity based compensation, concluding it is the best way of compensating a manager because it has the strongest pay to performance link (Hall and Liebman, 2003).

9 2.2.3 Equity based compensation A solution to the agency problem might be equity-based compensation. Research of Hall and Liebman (2003) showed that with equity based compensation the pay-performance relation is more positive because it gives a shared interest between managers and shareholders. When stock-based compensation is involved this drives the manager more to performance and so compensation is positive more related to performance (Hall and Liebman 2003). This result is consistent with research of Jensen and Murphy on the years , which found there is a strong pay-performance relation when CEO s receive equity based compensation. Mehran (1995) also found a positive relation between firm performance and equity-based compensation. According to the research of Hall and Liebman (2003) this equity-based compensation increased very large (relative to cash compensations). The reason equity-based compensation has increased like already mentioned because of the believe CEO s are more interested in shareholder value because when the share price increases, the pay-out of the stock options also increases. But another important reason Hall and Liebman (2003) find in their research is the increased elasticity of the compensation. Equity-based compensations is faster adjusted to firm performance, also when firm performance is going down. When a firm performance poorly, this immediately is reflected in the stock price, giving less compensation for the CEO. This gives equity-based compensation a benefit over cash-based compensation which has a low elasticity. Equity based compensation is based on call-options. When a manager performs well in the interest of the shareholders they are able to call this options and gain stock of the company and make a personal gain (because when a company performances this will have a positive influence on the share value). When a manager already holds stocks of a company (because of options rewarded in the past) this also has a positive influence on the performance. Research on the years , found there is a strong pay-performance relation when CEO s are holding stocks of the firm (Jensen and Murphy, 1990). Also Mehran (1995) found a positive relation between stockholdings of a CEO and firm performance. The problems with equity-based compensation are explained in the research by Core, Guay and Larcker (2001). First of all it is not easy to determine the right amount of stocks options assigned as a compensation. Across several different industries there has been different

10 amount of options compensation granted. For example growing industries like the computer have higher stock options compensation in comparison to low growing industries like the petroleum (Core and Guay, 2001). It is difficult to determine the right amount of stocks options for a CEO. According to Core et al. when a CEO owns to much stocks of a firm there is less separation of power between shareholders and the manager, which encourages the nonprofit incentives of a manager because there is less control. Even so, high equity based compensation can bring extra cost for shareholders. A manager who is depending a lot with his compensation on the value of a stock bears more risk for making a loose. For this risk managers want to be compensated with an extra cash premium which brings extra costs to the contract. (Core, Guay and Larcker, 2001) An important factor is personal wealth of a CEO (Lambert, Larcker, and Verrecchia, 1991). According to Lambert et al. (1991) most CEO s have personal stock portfolios with diversified risk. Equity-based compensation can change these portfolio values, because a manager has to diversify his own risk again. Even so managers that are less vulnerable to equity-based compensation because of their larger personal wealth are likely to perform less in the interest of the shareholders. Also the other way around when managers have low personal wealth they are more depending on the equity-based compensation, which involves extra risk for the manager which causes the manager to require a compensation for this risk. The research of Lambert et al. (1991) provided a framework which considers the personal wealth of a manager, taking into account the difference in which managers perceive the importance of equity-based compensation. The important conclusion is that the cost of a compensation contract for the shareholders is more than the value perceived by a manager, causing the compensation contract is not optimal Additional components of pay CEO s receive compensations in other ways, not as a bonus for performance. The first compensation they receive when signing a contract can be the so called entry benefit (Kerin, 2003). According to Kerin (2003) this is an amount of cash a person receives for taking the position of a CEO. The amount of this entry benefit depends on the status of a CEO, if a person to become a CEO has proven to be successful in the past with other companies, this is more likely to raise this entry benefit.. When a CEO ends his job there can also be compensation, the so called exit benefit (Kerin, 2003). According to Kerin (2003) these exit benefits are most of the time meant to convince a CEO to step out of his position. Without

11 these exit benefits it is not likely a CEO will step out by himself and firing him is more costly for the company. According to Bebchuk and Fried (2003) managers sometime get these payments without looking if they have performed for the company and even when they are replaced by the board. This harms the link between pay and performance, in case the manager is replaced by the board due to poor results (so a bad performance), the goodbye payment gives a compensation without performing. While these goodbye payments can have been arranged in the contract of a manager, Bebchuk and Fried provide evidence this payments can also exceed the level of payment which was originally arranged in the contract 2.3 Optimal contracting All of the prior mentioned compensations are set into a compensation contract for the manager because shareholders need the manager to manage a firm. They design a contract because they do not have the abilities to manage the firms themselves.. In this contract there is a compensation standard like with equity-based a number of stock options, which the manager receives if he meets the targets of the shareholders. The designer of this contract would like compensations that make sure to attract high quality executives, to serve shareholder interest, and minimizing overall costs (Bebchuk and Fried, 2002). The dominant approach to managerial compensation is to see contracting as a (partly) solution of the agency problem between managers and shareholders because it aligns interest in firm performance. The so called optimal contract approach (Bebchuk and Fried, 2003). These three solutions (with extra costs), so monitoring, bonding and an optimal contract are not substitutes for each other, they can be combined in every organisation. In the contract with a manager, shareholders need to determine the optimal compensation. This compensation standard can result from negotiations at arm s length, which means negotiations between shareholders and the manager, or by market constrains that induce these parties to adapt standards in the contract even without negotiation (Bebchuk and Fried, 2005). A contract is said to be optimal when it works in the best interest of the shareholders, so linking pay (the compensation of CEO s) to performance of a firm. Compensation contracts with equity-based compensation are the most important and the focus of this research because of the mentioned results in section which described the pay for performance relation with equity-based compensation.

12 2.3.1 Criticism on optimal contracting A criticism on the arm s length bargaining of compensation standards is the important tasks of board directors, who have to set compensation levels and compensation structure for managers. (Fama and Jensen, 1983) This is a reason why there has been research on the relation between board structure and the compensation structure. First of all research showed the structure of the board is important. Firms with more outside directors, so directors not working for the company are more independent of top management. (Mehran, 1995). Although outside directors have less influence on firm performance (because they are not directly involved in the company), having more outside directors leads to more equity-based compensation, which is according to Mehran (1995) assumed to better link pay to performance. Inside directors have some dependency with the top management. This dependency can be explained by several factors (Bebchuk and Fried, 2003). According to Bebchuk and Fried (2003) first of all the board of directors find their jobs contains prestige and status, which results in the board of directors wanted to be re-appointed. This reappointing is influenced by the CEO, so they want to have a positive working relation with the CEO. This causes them to maximize the level of compensation beyond the optimal level. Furthermore the board of directors also face an information asymmetry with the CEO s, because they lack access to independent information on firm performance, which harms the pay-performance relationship. According to Bebchuk and Fried (2003) another criticism on the optimal contracting is the failure of some constraints on the market. They give the example about hostile takeovers for the market of corporate control. In most companies there are staggered board of directors (a board of whose three year terms are staggered, so only a third is up for election each year (Berk, Demazo, 2007) which make hostile take overs harder because they are not replaced so easily. So to still come to a takeover, there is paid a large premium over the bid price. According to Bebchuk and Fried this premium was about 40%. This is giving the manager a benefit that has nothing to do with the pay-performance link, so a pay beyond the terms in the contract of a CEO. When a CEO receives pay beyond the set compensation in his contracts, this compensation is no longer optimal. This harms the incentive of an optimal compensation contract to align CEO interest with shareholders (CEO s in this case do not have to perform to get a pay).

13 2.4 Managerial power A whole other approach to the optimal contracting with equity-based compensation is when it is not seen as (partly) a solution of the agency problem, but as part of the agency problem. An important factor is the power of a manager to influence his compensation. A phenomenon in which managers influence their own compensation without looking at shareholder value is called rent extraction (Chalmers, Koh, Stapledon, 2006). According to Chalmers et al. (2006) rent extraction occurs when managers extract personal compensation values beyond the compensation contract, values that do not have to be consistent with firm performance. Because of these personal values their payments will be much higher in comparison to what managers should have been paid looking at performance. Another definition of rent extracting is that it is the excess of the pay a manager or CEO receives over what he would have received if pay was related to firm performance (Bebchuk and Fried, 2002). An approach in which rent extraction and power are seen as very high correlated is the managerial power approach (Bebchuk and Fried, 2004). According to Bebchuk and Fried (2004) the amount of influence of the manager on his compensation depends on several conditions. An important factor of the Bebchuk and Fried theory is the outrage of the compensation. Because a lot of publicly traded firms have to explain their compensation payments for managers in front of the stakeholders it is important compensation is not raising to many questions. Camouflage is also an important factor close related to this outrage of the theory of Bebchuk and Fried. With camouflage is meant the way managers can camouflage their compensation, in such a way it is not clear this compensation holds no ground when looking at the pay for performance. Camouflaged ways of compensation include providing the manager personal loans with lower interest than the market interest and by taking over the personal debt of a manager to improve his personal financial position.. Research proved agency problems are made worse when the manager has more power because of a weak board and ownership structure. As a consequence the firms with a weak board and ownership structure had to deal with a bigger agency problem, having a negative impact on performance. (Core, Holthausen, Larcker, 2003). Example of a weak board Core et al. (2003) give is the situation in which the CEO is also the board chair, which has the consequence the CEO can influence his own compensation even more. Another example they give is the situation in which board members of companies are also involved in other

14 companies, Core et al. (2003) proved in their research that when board members are involved in at least three other boards CEO compensations are higher without the firm performing better. 2.5 Pay for performance relation To answer if compensation is (partly) a solution of the agency problem or part of the problem, it is important to see if compensation is related to company performance. Although the earlier mentioned results of Hall and Liebman (2003) and Mehran (1995) suggest a positive pay for relation for equity-based compensation, there are results which found no pay for performance relation. A research in the Netherlands for the period found there is no evidence for a pay for performance relation. (Duffhues, Kabir, 2007) Also in the US there have been research on the pay-performance finding no pay-performance relation in the years (Brick, Palmon, Wald, 2005). So there is no definite conclusion yet about this payperformance relation. According to Duffhues and Kabir (2007) the amount of leverage is a factor that influences this pay for performance relation. More leverage would imply more monitoring of a CEO (by debt-holders), which has a positive influence on the pay-performance relation. But according to Duffhues and Kabir (2007) there is also another effect of leverage, it enlarges firm risk. When a CEO compensation is linked to firm performance, the CEO also bears more risk with more debt (because of the enlarged firm risk). This causes a CEO to want more compensation, which has a bad effect on the pay for performance relation. 2.6 Hypotheses After considering this past literature it is interesting to research how this results hold ground for more recent years. The first hypothesis is about the results by Hall and Liebman (2003) and Mehran (1995), who found a high positive pay-performance relation for equity-based compensation (explained in section 2.2 about the compensation structure ). Even though the results of these researches are not very recent it is expected this still holds some ground for more recent years. H1: Equity-based compensation will have a high correlation with firm performance measured by ROA and Tobin s Q.

15 The second hypothesis considers stockholdings of a CEO. For this hypotheses it is expected that CEO s that are in possession of stocks are more performing in the interest of shareholders, consistent with the results found by Jensen and Murphy(1990) and Mehran (1995) explained in section So stock possession should better align interest between shareholders and CEO s. H2: CEO s stockholding will have a positive influence on firm performance measured by ROA and Tobin s Q. The third hypothesis considers the leverage ratio of a firm. For this hypothesis it is expected a higher leverage ratio will have a positive influence on firm performance. As described in section 2.5 Duffhues and Kabir (2007) describe one effect of a higher leverage ratio is that more debt will indicate more monitoring, this will have a positive influence on the behaviour of a CEO to perform in the interest of the shareholders, causing to have a positive influence on firm performance. H3: A higher leverage ratio will have a positive influence on firm performance measured by ROA and Tobin s Q.

16 Chapter 3: Data and methodology This research will focus on CEO compensation. To investigate the relations between (equitybased) compensation, CEO stockholdings and firm performance this research will be looking at US publicly traded firms on the S&P 500. These firms are all restricted to the NYSE(New York stock exchange). The data for CEO stockholdings and the equity-based compensation will be collected from a COMPUSTAT(EXUCOMP) database. The financial data which is necessary to determine firm performance is collected from the CRSP/Compustat Merged database. Together these data is merged using Stata. This research will focus on the years , because this period is before the financial crisis which might have an influence on the results. But it has to be considered these years include the dot.com bubble which burst in march 2000 and had impact on the years following. This is still a relevant period of time, because little research is known about equity-based compensation for this more recent years. The sample of nine years is chosen to get relevant data concerning the fluctuations there might be in the compensations for CEO s. After filtering out the non CEO data the database used consists out of 2254 observations, spread over time. 3.1 Dependent variable The dependent variable of this research is firm performance. To be consistent with other researches firm performance will be measured with accounting variables ROA (return on assets) and Tobin s Q. The reason for these variables is because they provide information to the board about the firm value added by the CEO (Mehran, 1995). With the collected data these performance measures will have the following formula s : (1). ROA (2). (Tobin s)q (Where Market value of assets is determined as the book value of assets + market value of common stocks book value of common stocks- balanced sheet deferred taxes, consistent with prior research of (Fahlenbrach and Stulz 2009))

17 3.2 Independent variables Because this research is looking at the pay-performance relation for CEO s, the independent variables are different components of CEO equity-based compensation. Next to this there will be looked at stock possession for CEO s. These are the same variables used as in comparable research from Mehran (1995). When looking at total equity-based compensation, the following variables are concerned: Restricted stock grants: the stocks that are granted for CEO s. Options grants (valued by Black-Scholes): the options that are granted for a CEO. Like described in the literary review it is expected this total equity-based compensation is best linked with performance of a firm. This are the same two variables used in the research of Mehran (1995). When looking at stock possession of a CEO the following variable is concerned: Stocks held by a CEO: a percentage of all stocks outstanding, which describes the percentage of the amount of stocks a CEO holds into a certain firm compared to all stocks outstanding. 3.3 Control variables The control variables used will be consistent with the research from Mehran (1995), these control variables are expected to result for a higher adjusted r², so in other words these control variables explain more of the fluctuations in performance and the variables concerned in the regression. The following control variables are used: Leverage ratio: Duffhues and Kabir (2007) described leverage can have an effect on the pay for performance relation. The amount of debt of a certain firm is calculated with the following formula: (1). Leverage ratio =. Growth opportunity of a firm: In the research of Mehran (1995) it showed this a significant variable when calculating the pay-performance relation. The growth opportunity is calculated with the following formula consistent with the research of Mehran (1995): (2). Growth

18 Firm size: It is important to include firm size, as it is expected bigger firms have more resources available for compensation (Mehran 1995). Firm size is calculated using the following formula consistent with prior research of Mehran (1995): (3). Firm size = LOG of the total value of assets Assets in place: A control variable used in the research of Mehran (1995). This variable is calculated as: (4). Assets in place 3.4 Empirical model To research if equity-based compensation has a positive pay for performance relation a regression analysis will follow. This regression will be on a no constant basis to be consistent with prior research of Mehran (1995). The regression formulas will hold the two performance measures ROA and Tobin s Q as depended variable, while the other discussed variables will be independent variables. Each depended variable will hold his own equation, the first describes the model when ROA is used as a performance measure, in the second equation Tobin s Q is the performance measure. Both regression formulas are consistent with research of Mehran (1995). (1) ROA (2) Q

19 Chapter 4: Empirical results 4.1 Descriptive analysis Like described in chapter 3 the dataset for the years consists out of 2254 observations. These observations are not spread equally over the years, until 2005 there is a growing number of companies providing information about their CEO compensation, CEO stock ownership and their financial performances. Table 4.1 shows statistics for these companies with respect to the percentage of CEO stock ownership. Table 4.1: Summary statistics for percentage of CEO stock ownership: The distribution of the percentage of CEO stock ownership per year for companies listed on the NYSE for the years The mean is a percentage of total stock holdings of a firm, held by a CEO. Distribution is shown with the quartiles and median. YEAR Mean SD 1 st quart Median 3 rd quart N While in 1996 the number of companies is 115, the smallest of the sample, the mean of the percentage of stock ownership is the largest namely %. As the number of companies increases over the years, the percentage of CEO stockholdings decreases to the lowest point in 2004, where the mean is %. For all years both quartiles and the median is zero, so every year the conclusion can be drawn that from the total number of companies there is only a small fraction of all firms with CEO stockholdings. The standard deviation of all years shows there are companies in this small fraction with well above the mean CEO stockholdings. Over the years the average for CEO stockholdings is %.

20 Table 4.2 shows summary statistics for the equity-based compensation per year. Like described in chapter 3 total equity-based compensation consists out of restricted stock grants and option awards presented in respectively panel B and panel C. Table 4.2: Summary statistics for equity-based compensation: The table presents all equity-based compensation for the years for companies listed on the NYSE. Panel A describes total equity-based compensation as the sum of Panel B the restricted stock grants and Panel C the stock option awards valued by Black-Scholes. All monetary amounts are in US dollars. A: Total Equity-based Compensation Year Mean SD 1 st quart Median 3 rd quart N B: Restricted stock grants C: Stock options awards valued by Black-Scholes The total equity-based compensation mean in 2005 is as 5 times as large as the total equitybased compensation in 1996, from $ in 1996 to $ in While this is a large increase, this does not imply the compensation has raised every year. For the years 1996

21 to 2001 and in 2003 to 2005 the total compensation increased, but in the period there was a decreasing. The slope of total compensation can be seen in graph 4.1. The decreasing of compensation can be explained by the IT bubble, which burst in 2000 and had his effect for the next few years until For all years these stock options granted determine the largest part of the equity-based compensation. But the part of total equity compensation that is determined by these stock options granted has decreased over the years and on the other hand there is an increase in the restricted stock grants. Looking at table 4.2 shows that in 1996 about 23% of the total equity compensation was restricted stock compared to about 41% in Although this is a significant increase, not all companies in the sample provide these restricted stocks which can be seen by the zero of the first quartile every year in table 4.2. This does not change the overall conclusion that both components of equity-based compensation has raised during the period 1996 to 2005(as can be seen in the graph) and has an average dollar value of Graph 4.1: Total equity-based managerial compensation trend: total equity-based compensation trend for companies listed on the NYSE, for the years Total equity-compensation is the sum of res. stock grants and stock options valued by Black-Scholes. Monetary value US dollars. Values of the graph can be found in table 4.1 panel A , , , , , , , , , ,0000 0,0000 total equity-based managerial compensation in $ ( ) tot equity Table 4.3 shows a summary of the statistics for performance of the companies, measured in panel A by the return on assets and in panel B by Tobin s Q. While the mean of both performance measurements has increased slightly from 1996 to 2005, they both fluctuate over the years. In comparison with table 4.2 it is interesting to see for the period the

22 mean of the total equity-based compensation has increased, while mean of the performance of the companies has decreased for the period when looking at the ROA and for when looking at Tobin s Q. Table 4.3: Summary statistics for performance: Summary statistics for performance of the companies listed on the NYSE for the years Panel A is measured as the ratio of net income to total assets, panel B as the ratio of market value of total assets to book value of total assets. Panel A: Performance measure ROA Years Mean SD 1 st quart Median 3 rd quart N , Panel B: Performance measure Tobin s Q But there can be no conclusions drawn yet for the pay for performance relationship, this will become clear in the linear regression in section 4.2. The average for ROA for the whole period is and with respect to Tobin s Q. Table 4.4 summarises the other variables that will be used in the linear regression in the next section. This table for the years shows the variable growth is not large for this sample, with both quartiles and the median of zero and even a slightly negative mean. The spread with both zero quartiles even shows a lot of companies do not have expenses for research development. Hence, growth is calculated as the ratio of research & development by reported sales. Furthermore the next section there will be checked on the leverage ratio, the size and the so called assets in place which are spread around the mean.

23 Table 4.4 Summary statistics for the control variables: Summary statistics of the control variables for all companies in the NYSE for the years Lev. Ratio calculated as the ratio of long-term debt to total assets, growth as the ratio of r&d to sales, size as the log of total assets and assets in place as the ratio of inventory plus gross plant and equipment to total assets. Mean Sd 1 st quart Median 3 rd quart N Lev ratio Growth Size Assets in place 4.2 Regression Analysis Table 4.5a and b show results of regressing firm performance on equity-based compensation. Panel A uses return on assets as a measurement for firm performance, while panel B uses Tobin s Q as the dependent variable of firm performance. Consistent with prior research of Mehran (1995) this regression table is split up into four columns. Column 1 in both tables is the regression result of performance as depended variable against both forms of equity-based compensation. As indicated with three asterisks both forms of equity-based compensation are statistically significant at a 0.01 level. Even so, the coefficient of these two forms of equitybased compensation is positive, although this is a small coefficient (close to zero) this indicates a (little) positive relation with firm performance. This causes a trade- off between the positive equity-based compensation coefficient that indicate a positive pay for performance which serves the best interest for the shareholders, against the just little effect of the compensation on performance caused by the low coefficients. These results for the first column are consistent with prior research from Mehran (1995) and Hall and Liebman (2003), who also found a positive influence of equity-based compensation on firm performance for the past years. The research of Mehran found larger coefficients, but this can be explained by the difference in variables where Mehran uses equity-based compensation as a percentage of other forms of cash-based compensations which are not relevant for this research. The second column of both tables shows the regressed results of the percentage of stockholding of a CEO against firm performance. Again this number is statistically significant at a 0.01 level and has a positive coefficient. These results are supported by prior research of Mehran (1995) who found this results for other periods of time and by Jensen and Meckling (1976). Jensen and Meckling found that CEO stockholdings gives the CEO incentives to work

24 harder, because the value of his stocks increases when the firm is performing, which decreases the agency problem between CEO s and shareholders Table 4.5a: Dependent variable ROA: Regression results for return on assets as a dependent variable for all companies in the NYSE for the years Three asterisk*** indicate a significance level at Other significance levels of 0.05 and 0.1 where not found. Column (1): regression results equity-based compensation against performance, Column (2): regression results of %stock held by CEO against performance, Column (3): regression results equity-based compensation and %stock held by CEO against performance, Column (4): regression results of equity based compensation, %stock held by CEO and the control variables (Lev ratio, Growth, Size, Assets in place) against performance. Independent variables (1) (2) (3) (4) Res. Stock grants 5.03e-06 (7.69)*** 4.86e-06 (7.53)*** 7.77e-07 (0.76) Options grants 2.76e-06 (10.94)*** 2.68e-06 (10.75)*** 4.30e-07 (3.53)*** % stock held by CEO (8.50)*** (7.96)*** (3.07)*** Lev ratio (-6.20)*** Growth (0.07) Size (12.89)*** Assets in place (10.69)*** Adjusted R² F-statistic Obs The third column of both tables shows the regressed results when the two variables of equitybased compensation and the percentage of CEO stockholdings is regressed with firm performance. For all three variables the results are the same as in the first two columns, so again with positive coefficients and significance at a 0.01 level. Just like in the first column these coefficients are close to zero and different from research of Mehran (1995), but again this difference can be explained by the difference in variables of equity-based compensation. Mehran (1995) uses percentages of equity-based compensation, while this research uses US dollar values. For both tables the three variables together have a higher adjusted R², and indicating that around 12% and 19% of the fluctuations in the performance is