CEO Option Compensation Can Be a Bad Option: Evidence from Product Market Relationships

Option compensation is recognized as an important component of executive pay. Despite existing research generally concluding that awarding stock option grants to senior executives leads to greater firm risk taking, the literature finds inconclusive evidence about CEO option-based compensation’s impact on firm value. We hypothesize the inconclusive findings on the option-performance link is at least partially due to fact that options can intensify conflicts of interests between shareholders and debtholders and other important stakeholders with debt-like claims such as large customers. We empirically examine this proposition on whether executive option compensation can undermine these valuable stakeholder relationships, and thereby lead to weakened future firm performance and value.

In this study, we exploit U.S. tariff reductions that occur in different industries at different points in time as exogenous shocks to existing customer-supplier relationships. We find novel evidence that this negative shock to the bargaining power of suppliers relative to large customers has a first-order negative effect on the proportion of a supplier’s option-based CEO compensation.  We also find that following such competitive shocks, leaving existing CEO option compensation unchanged undercuts firm performance in the presence of major customer relationships.  Moreover, these relationships measurably weaken. Economically, we find that conditional on the existence of large customers, a 1% increase in the fraction of CEO option-based compensation is predicted to reduce a supplier’s Tobin’s Q by about 2%-3%.  We also find evidence that a significant reduction in sales to its large customer and a significant increase in the likelihood of the large customer terminating the relationship are two channels that help explain this change in firm value.

This study sheds new light on the importance of customer-supplier relationships on firm value and performance, as well as on optimal CEO compensation policy. These results support the view that firms modify their major governance mechanisms to bond their actions so as to reassure important stakeholders. These results also suggest that when making governance decisions, firms can face serious implicit or explicit constraints, which are imposed upon them by important stakeholders. Finally, we provide the first evidence that the presence of a large commercial contract measurably affects the choice of a CEO’s compensation contract.

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Ronald Masulis is the Scientia Professor in Finance at the Australian School of Business, University of New South Wales and an ECGI Research Member.

Claire Yang Liu is a Senior Lecturer in the Discipline of Finance at the University of Sydney Business School.

Jared Stanfield is an Assistant Professor of Finance University of Oklahoma.

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