Growth options, incentives, and pay for performance: Theory and evidence

Pay-performance sensitivity is a common proxy for the strength of incentives. We show that growth options create a wedge between expected-pay-effort sensitivity, which determines actual incentives, and pay-performance sensitivity, which is the ratio of expected-pay-effort to performance-effort sensitivity. An increase in growth option intensity can increase performance-effort sensitivity more than expected-pay-effort sensitivity so that, as incentives increase, pay-performance sensitivity decreases. We document empirical evidence consistent with this finding. Pay-performance sensitivity, measured by dollar changes in manager wealth over dollar changes in firm value, decreases with proxies for growth option intensity and increases with proxies for growth option exercise.

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