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 :

August 21 2020
SSRN Share

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 all informative signals. This paper studies how such signals should affect the contract, in a general model with continuous effort, risk aversion, and limited liability. The optimal contract pays zero when output falls below a threshold.

Surprisingly, “good” signals of performance need not lower the threshold, because a signal is not only individually informative about effort { it also affects the information output provides about effort. A signal that indicates that the output distribution has shifted to the left (e.g. weak industry performance) lowers the threshold; one that indicates that output is a precise measure of effort (e.g. low volatility) lowers high thresholds and increases low thresholds. We apply our model to performance-based vesting and show that performance measures should affect the threshold (i.e. strike price) rather than the number of vesting options, contrary to common practice.

Authors

Real name:
Pierre Chaigneau
Real name:
Daniel Gottlieb