Bonuses (Employee for Performance)
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Bonuses are variables payments assigned to employees upon reaching some predefined goals. The bonus pays are usually tied to company outcomes (e.g., profits, share price, sales, customer satisfaction) as well as linked to specific employee’s area of responsibility so as to allow the identification of the individual efforts and results. Bonuses pays could be tied to the achievement of short-term, intermediate-term, and long-term goals.
Over the last decades, firms have radically changed their pay practices, especially at managerial level, where employees are given much greater benefits for the services they provide, and a much larger portion of their pay is based on the firm performance or deemed “at risk” (Magnan and Martin 2019).
Indeed, it is worth noting that the employee compensation can be made up of various components and, besides the fixed cash salary, there are a lot of additional and nonmonetary benefits (e.g., tax consultant services, medical check-ups, company car, furniture for company housing) as well as perquisites (e.g., club memberships). Nevertheless, in recent years the biggest part of the remuneration consists of the performance-based rewards, as additional monetary benefits which mostly consist of direct (cash) bonuses or equity-based bonuses (Luthans and Stajkovic 1999). Anecdotal evidence confirms this trend. Indeed, looking at top managerial compensation, there is the case of the CEO of Chrysler, Lee Iacocca, who gained a nominal cash salary of $1 but earned $35 million in stock options gains (Catuogno et al. 2016a, b). Additionally, according to a study provided by the Hay Group in 2009 on the CEO compensation in US, while the CEO base salaries have significantly decreased from 2008 to 2009, in the same time frame the annual incentive pay grew of 3.4%. Indeed, the number of organizations that largely employ incentive plans in order to remunerate and reward the performance of outperforming employees has significantly increased (Falola et al. 2014). The main aim is to design the incentive packages to get the maximum performance from their employees as well as to retain the most productive ones among them (Arnold 2013).
Scholars suggest that an adequate incentive-based compensation scheme represents a crucial instrument through which organizations can motivate and increase their workers’ performance. Indeed, studies belonging to different field (e.g., management literature, accounting literature) have documented that the use of incentive plan in employees’ compensation influences workers performance by inducing a higher level of their efforts (Gomez-Mejia et al. 1987; Tosi and Gomez-Mejia 1994; Chow 1983; Waller and Chow 1985; Chow et al. 1988). Also, there are many studies that have empirically examined the implications of incentives plans for firm outcomes (Al-Nsour 2012; Arnolds and Venter 2007; Banker et al. 1996). Overall, these studies document that measuring and rewarding the performance of employees encourage and sustain employee contributions to the success of the organization for a number of reasons (Milkovich et al. 2010).
First of all, according to the expectancy theory, the employees’ motivation and therefore their productivity are enhanced as their behaviors are highly instrumental in achieving the desired outcomes. Indeed, linking the employees’ compensation to the outcomes of their behaviors, enhances the expectation of receiving rewards tied to a specific outcome as well as the motivation of employees to engage in the behaviors that allow to achieve the desired outcomes (Gerhart and Milkovich 1990; De Kok et al. 2006). In this regard, scholars suggest that performance-based remuneration system in which efforts and rewards are characterized by specific individual goals, represent the best tool to increase the employee’s motivation (Fay and Thompson 2001).
From a different standpoint, research enlightens that incentive compensations are able to align the interests of employee and owners, especially with regard to employees at managerial level (Kruse et al. 2010). In this regard, according to the agency theory, the incentive performance-based bonuses are able to address the conflicts of interest between the owner (i.e., principal) and the employee (i.e., agent) (Jensen and Meckling 1976). Indeed, the theory stems from the problem of the employment which involves that the owner delegates his work to an agent who performs his job in return for some remuneration. However, as a self-interested rationalist, the agent will try to avoid performing the contracted obligations by taking advantage of the principal inability to control all aspects of his behaviors. In this regard, the principal could invest in monitoring behavior or, in alternative, in using incentive compensation systems that rewards the agent based on firm outcomes, so as to resolve the above-mentioned issue (Gerhart and Milkovich 1990). Indeed, by making workers’ remuneration contingent on organizational-level outcomes, such as shareholder profit or value creation (Ross 1973), employees are better able to behave as owners and are also more likely to take risk (Coles et al. 2006; Edmans and Gabaix 2011; Gormley et al. 2013; Hayes et al. 2012).
Additional benefits of using remuneration packages that include variables payments compensation are linked to the firm’s ability to draw talented employees compared with untalented ones (Hancock et al. 2013; Long et al. 2002). Indeed, as brilliant employees are more confident to increase company value, they are more committed to do so (Chrisman et al. 2017; Long 2000), with obviously positive implications in terms of the improvement of the level of firm performance.
Finally, the positive implications of incentive compensations also occur in terms of group coordination. This is especially true when the employees reward is based on the product of group-based assessments instead of individual ones, as it increases the degree of cooperation among employees within the firm (Blinder 2011; Nyberg et al. 2016). Indeed, the performance group-based compensation encourages employees to monitor each other by hampering the level of the team effort and productivity and by reducing the free-riding co-workers effect (Kruse et al. 2012).
Stock-Based Incentive Compensation Plans
Among several key components of bonuses, stock-based incentive compensation plans are recognized as the most effective way to relate pay to performance (Zattoni 2007). This is especially true for employee at managerial level as they usually represent the main part of the overall managerial compensation. Indeed, Damodaran (2015) documents that on average, in 2013, 70% of the CEO compensation package in US is equity-based, while cash compensation (salary and cash bonuses) is lower than 25%.
From a technical point of view, literature has classified stock-based incentive compensation plans into two main groups: (i) non stock option plans and (ii) stock option plans. While the former link employees’ remuneration to the value of firms’ shares, the latter provide employees with the possibility to buy or subscribe company shares (Bernhardt 1999; Zattoni and Minichilli 2009).
Focusing the attention on non-option stock plans, these tools can be classified into two categories (Zattoni 2007). The former has a higher incentive goal and includes those plans granting a reward to employees for achieving certain targets. This is the case of phantom stocks that give a bonus (in cash or stock) if the firm share price has increased, or additionally of stock appreciation rights that assign to employees a cash premium award equal to the difference between the market share price and a predefined strike price. The second group of non-option stock plans is composed by share ownership plans, where granting share is part of a more general employee shareholding scheme. This group includes instruments that assign stocks to workers, free or under convenient conditions (i.e., stock grants) or that they have to sell back to the company whenever some targets are not achieved (i.e., restricted stock plans) (Zattoni 2007; Catuogno 2013).
Shifting the focus on the stock option plans, this kind of incentive plans give workers the right to buy or subscribe stocks, after (i.e., vesting period) and within (i.e., exercise period) a certain time period, at a predifined price (i.e., strike price), and sometimes conditionally to the achievement of some firm performance targets (Zattoni 2007). These bonuses represent a motivational contract tool as employees are encouraged to increase the value of company shares because if it overcomes the strike price, they can buy and later sell firm stocks, gaining the difference between the strike and selling prices (Jensen and Murphy 1990). Irrespective of the aim of stock option plans, it is worth noting that these tools can differ according several variables such as the qualification of the involved employees (i.e., broad-based stock option vs executive stock option plans), the method of presetting the strike prices (i.e., fixed stock option plans, variable stock option plans, or indexed stock option plans), or the presence of a link with a firm performance variable (i.e., market performance plans vs enterprise performance plans).
Despite stock option plans and non-stock option plans present some basic similarities as they both link managerial remuneration to the value of the firm’s equity, the abovementioned peculiarities involve that they overall differ in terms of risk profile, motivational effect, financial resource required and link with the achievement of firm targets (Zattoni 2007).
Stock Option Plans
Literature has interpreted the use of stock option plans as a compensation tool in the light of the agency problem between managers and shareholders in Anglosaxon public companies (Berle and Means 1932; Catuogno et al. 2016a). Indeed, according the optimal contracting theory, by linking executives compensation to shareholder value, stock options represent a governance tool able to diminish managerial opportunism and to align the interests of managers (agents) and owners (principal) (Ross 1973; Zattoni 2007; Holmstrom and Costa 1986; Jensen and Meckling 1976). Following the alignment rationale, stock options represent a tool able to increase the company performance and maximize the shareholder value (Jensen and Meckling 1976). Indeed, by providing managers with a proprietary interest in the company, they will achieve both their own and shareholder goals (Murphy 1999).
However, some recent financial scandals in European and US companies have suggested that stock option plans can often fail to solve the conflicting interests in dispersed ownership structures (Terviö 2008; Tosi et al. 2003), and they are also sometimes employed in the presence of blockholders (Catuogno et al. 2016a; Melis et al. 2012; Zattoni 2007).
In this regard, proponents of the rent extraction view (Bebchuk et al. 2002) have suggested that that stock options may represent an additional tool for powerful opportunistic managers to increase their wages and “camouflage” inefficient wealth transfers from shareholders to them (Bebchuk and Fried 2003, 2006; Hall and Murphy 2002). Still building on the agency theory, this framework suggests that powerful managers receive a pay in excess (i.e., a rent) of the optimal level as they are able to condition their own compensation arrangements (Bebchuk et al. 2010; Bebchuk and Fried 2006). In this regard, literature suggests that badly designed stock option plans may usually represent a signal of the agency conflict, instead of a governance mechanism able to solve it (Bebchuk et al. 2002; Bebchuk and Fried 2006; Terviö 2008; Barontini and Bozzi 2009).
Building on this, it is worth noting that the aim of stock option can be interpreted as a double-edge sword. However, scholars have suggested that the design of stock options plan is able to ensure the alignment aim of stock option (Catuogno et al. 2016a). Indeed, governance literature advocates that the strike price, the vesting period, the lockup period, the vesting conditions, and the repricing play a crucial role to define an effective stock option plan (Catuogno et al. 2016b; Bebchuk et al. 2010; Kuang and Qin 2009). More specifically, both research and practice emphasize that the abovementioned elements should be effectively designed in order to achieve a long-term remuneration perspective that motivates managers to take value-maximizing decisions (Catuogno et al. 2016b).
First of all, with regard to the strike price, research documents that setting the exercise price equal or higher than the current share market price at the assignment date increases the managerial incentive to pursue shareholder wealth and to boost the shareholders’ returns (Bebchuk and Fried 2006). Therefore, an at-the-money/out-of-the-money strike price pushes managers to increase the market stock price so as to benefit from the emerging capital gain (Catuogno et al. 2016b; Zattoni 2007). Opposite conclusions are drawn if at the assignment day the strike price is already equal to the current market value of the underlining share, as the option is already in the money, and managers are not incentivized to achieve the shareholder value maximization (Bebchuk and Fried 2006; Zattoni 2007; Balsam and Miharjo 2007).
Shifting the focus on the vesting period, studies document that the an effective design of stock option plans requires a long vesting period in order to avoid the “managerial myopia” (Catuogno et al. 2016b; Peng and Roell 2008), as it involves a higher share prices at the exercise date (Liljeblom et al. 2011; Fudenberg et al. 1990). Similar conclusions can be drawn with regard to the lockup period, as its presence pushes managers toward medium-/long-term firms goals. Indeed, executives are dissuaded to adopt a short-term opportunistic behavior due to their inability to shortly exercise the options and sell the shares (Melis et al. 2012; Zattoni and Minichilli 2009). Thus, studies in this tradition advocate that both the presence and the length of vesting, and lockup periods are crucial for the achievement of the rent extraction or the alignment purposes (Wheeler 2004).
Literature suggests that an additional element able to influence the effective design of stock option plan is the existence of an indexed strike price as a vesting condition (Catuogno et al. 2016a; Bebchuk et al. 2002; Sautner and Weber 2016). Indexed exercise prices ensure that managers are rewarded only if they really provide a contribution to the rise of company value. The underlying assumption is that the stock price changes could be not completely linked to the managerial performance, but influenced by market trends and expectations (Kuang and Qin 2009; Bertrand and Mullainathan 2001; Johnson and Tian 2000). However, indexed strike prices ensures that the options can be exercised when company share prices exceeds their market peers share prices (Hall and Liebman 1998), avoiding that executives are rewarded even if they have not conditioned the rise of company value (Bebchuk et al. 2002).
Finally, it is worth noting that an efficient design of stock option plans should not allow to re-set the exercise price if the original one is higher than the current value of the stocks (Chen 2004). Indeed, this could allow executives to gain boundless remunerations if the market price increase, or to protect themeselves from the losses in the opposite case (Catuogno et al. 2016b; Catuogno 2013). Therefore, scholars suggest that the repricing is able to challenge the alignment aim of stock options leading to the rent extraction purpose (Chance et al. 2000; Chidambaran and Prabhala 2003).
This entry illustrates the main objective and characteristics of incentive compensation plan, with particular reference to the equity-based ones.
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