Academics, regulators, and investors have been urging firms to tie executive pay to the long-term stock price. In the paper, Share Repurchases, Equity Issuances, and the Optimal Design of Executive Pay, which was recently made publicly available on SSRN, I explain why tying executive pay to the future value of the firm’s stock—even the stock’s long-term value—can sometimes perversely reward executives for taking steps that reduce the value flowing from the firm to its public investors over time.
The paper describes and analyzes two distortions caused by tying an executive’s payoff to a stock’s future value. The first is “costly contraction:” when the stock’s current price is below its actual value, the executive may have an incentive to divert cash from productive projects in the firm to fund bargain-price share repurchases. If the stock trades for a low enough price, a bargain-price repurchase can boost the value of the executive’s shares even if the repurchase forces the firm to cut back on profitable investments.