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Carrots or Sticks? Optimal Compensation for Firm Managers

We investigate the existence of and explicitly characterize compensation structures that eliminate agency conflicts between a leveraged firm (or its shareholders) and the manager due to managerial asset substitution within a continuous time framework. The manager may dynamically switch between two strategies with different risks and expected returns after debt is in place. We show that when the strategies satisfy a specific condition that (roughly) ensures that the difference in their drifts is not large compared with the difference in their volatilities, a periodic compensation structure that completely aligns the manager’s interests with those of the firm (or its shareholders) is one where the manager’s payoff is proportional to the firm’s operating cash flows, but subject to a floor and a ceiling. This result explains the prevalence of compensation schemes where firm managers obtain shares of firm profits subject to floors and ceilings apart from the usual components of cash, stock, and options. We also investigate conditions under which convex and concave compensation structures are optimal. We show that a concave compensation structure where the manager obtains a proportion of firm cash flows subject to a ceiling is optimal when the higher volatility strategy also has a higher expected return. On the other hand, a convex compensation structure where the manager obtains a proportion of firm cash flows subject to a floor is optimal when the higher volatility strategy has a lower expected return. Our theoretical analysis therefore offers insights into features of compensation contracts that mitigate agency conflicts due to managerial asset substitution.