Economic Consequences of Equity Compensation Disclosure

The primary role of equity compensation is to provide incentives to an effort-averse agent. Here, the author shows that the chosen level of equity incentives, when publicly disclosed, will also convey information about future earnings, causing two-way linkages between incentive compensation, and financial reporting. If (a) market prices respond more (less) to information, (b) the manager is more (less) risk averse, or (c) earnings are more (less) noisy, then the firm's owners choose more pronounced (muted) incentives, in turn leading to greater (lower) future earnings. The model explains observed spurious correlations between firm performance and executive compensation, and it provides several new predictions linking managerial, earnings, and market determinants to optimal equity holdings.