How Should Performance Signals Affect Contracts?

How Should Performance Signals Affect Contracts?

Pierre Chaigneau, Alex Edmans, Daniel Gottlieb

Series number :

Serial Number: 
439/2014

Date posted :

September 01 2014

Last revised :

March 18 2021
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Keywords

  • Informativeness principle • 
  • Limited Liability • 
  • option repricing • 
  • pay-for-luck • 
  • performance-based vesting • 
  • performance-sensitive debt

The informativeness principle demonstrates that a contract should depend on informative signals. This paper studies how it should do so. Signals that indicate the output distribution has shifted to the left (e.g. weak industry performance) reduce the threshold for the manager to be paid; those that indicate output is a precise measure of effort (e.g.

low volatility) decrease high thresholds and increase low thresholds. Surprisingly, “good” signals of performance need not reduce the threshold. Applying our model to performance-based vesting, we show that performance measures should affect the strike price rather than the number of vesting options, contrary to practice.

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Published in

Published in: 
Publication Title: 
Review of Financial Studies, Forthcoming

Authors

Real name:
Pierre Chaigneau
Real name:
Daniel Gottlieb