Equity has become a dominant component of CEO compensation in the past three decades due to its ability to align the interests of managers and shareholders. Each year, a firm can award its CEO either a certain number (share-based) or a given dollar value (value-based) of equity grants. In a new paper, we investigate the different incentives induced by value-based equity grants compared with share-based grants, their impacts on R&D investment, and their economic determinants.

Under a share-based equity grant, the number of shares a CEO receives is predetermined, and the total dollar amount of equity on the grant day is a function of the stock price. This relationship is in line with the classic incentive-contract models, which hold that more incentives should be offered to CEOs with greater marginal productivity. In contrast, under a value-based equity grant, the value of the grant is predetermined and the number of shares a CEO receives is derived from the given value and the grant-day stock price (and the parameters of the options). As such, a value-based equity grant generates a negative relationship between recent stock performance and the number of shares granted: A CEO whose firm has performed better receives fewer shares of stock or options on the grant day. Such a relationship is problematic because it violates optimal incentive design.

Three compensation practices can lead to value-based equity grants. The first and most obvious is fixing the dollar amount of equity grants during the span of a multi-year contract (the fixed-value equity plan). We consider any compensation contract as a “fixed-value equity plan” if the dollar amount of option grants, stock grants, or total equity pay is pre-fixed. During our sample period from 2006 to 2022, about 22.7 percent of S&P1500 firm-years use fixed-value equity plans.

The other two pay practices, although commonly observed, are less obvious than the first. Specifically, the second practice is pre-setting the pay structure of a CEO’s compensation (pre-set pay structure) – that is, pre-setting the ratio of values between equity and total pay, or between different components of equity pay. Because the price movements of stock and options are volatile and their relationship is irregular, a pre-set pay structure is highly unlikely unless the dollar amounts of stock and option grants in the contract are pre-set, i.e., value-based equity grants. We find that about 40.6 percent of our sample firm-years pre-set the pay structure of their CEOs’ compensation.

The third value-based practice is strict pay tracking, in which the board pre-selects a compensation benchmark and closely tracks its CEO’s compensation on this benchmark. When a firm’s stock price does not perfectly correlate with those of the firm’s benchmark companies, pre-setting the total value of CEO equity grants (along with non-equity pay) is the most effective way for tracking purposes. About 57.1 percent of our sample firm-years practice strict pay tracking.

Value-based equity grants from the above practices can affect executive incentives in two distinct ways. First, value-based equity grants can weaken the relationship between pay and prior performance, leading to a “pay without performance” effect. This is because under a value-based practice, the dollar amount of equity pay is often determined by factors unrelated to the firm’s past performance. For example, under a multi-year fixed-value contract, the total amount of equity pay is fixed regardless of the stock performance.

Second, a value-based equity grant can weaken a CEO’s incentives to perform well. Recall that a value-based equity grant creates an inverse relationship between stock performance and the number of shares granted: When the stock performs better, the CEO receives fewer shares. Moreover, under persistent value-based grants, this effect can build up and manifest in the portfolio holdings of a CEO, eventually lowering her portfolio delta. We find strong empirical evidence supporting both these effects.

The weakened CEO incentives may discourage CEOs from exerting more effort to increase a firm’s value. To explore the real consequence of these value-based practices, we examine their impact on corporate R&D investment decisions, as innovation has been shown to both require tremendous effort and enhance firm value and growth. Two instrumental variable (IV) regression strategies allow us to make a causal claim. The first IV strategy utilizes the fact that firms on fixed-value plans tend to use repeated cycles of equal length, while the second strategy focuses on the practice of presetting pay structure and exploits a mandatory vote on the frequency of say-on-pay for identification. Under both identification strategies, we find that value-based equity grants lead to lower R&D investment growth.

Finally, our paper examines why boards adopt these incentive-weakening pay practices. Retention is often claimed as the key reason for pay tracking.  Retention could also motivate the use of pre-set pay structure because such a practice facilitates the comparison of a firm’s pay structure with its peers. Furthermore, value-based equity grants could help with retention because they reduce compensation risk, which appeals to risk-averse executives. We find strong evidence that retention pressure results in greater use of value-based CEO equity grants. There is also suggestive evidence that governance might matter.

In our paper, we make two major contributions. First, two popular pay-setting mechanisms – presetting pay structure and compensation benchmarking – result in value-based equity grants, and we show that such practices lead to lower R&D investment growth. As such, our findings should help alert boards to the unintended consequences of pursuing a target pay level or structure. Second, retention and incentives are the two main goals of executive compensation. However, recent survey evidence suggests that boards and investors differ drastically in whether they give retention or. incentives priority in setting CEO compensation. Pay practices motivated by retention pressure lead to suboptimal incentives. Thus, the disagreement about which goal is more important can create conflicts between boards and investors.

This post comes to us from Jin Xu and Pengfei Ye at Virginia Tech University and Cheng Zhang at Shanghai University of Finance and Economics. It is based on their recent paper, “Value-Based CEO Equity Grants,” forthcoming in the Journal of Financial and Quantitative Analysis and available here.