The Value of Performance Signals Under Limited Liability

The Value of Performance Signals Under Limited Liability

Pierre Chaigneau, Alex Edmans, Daniel Gottlieb

Series number :

Serial Number: 
439/2014

Date posted :

September 01 2014

Last revised :

June 14 2019
SSRN Share

Keywords

  • Informativeness principle • 
  • contract theory • 
  • principal-agent model • 
  • Limited Liability • 
  • pay-for-luck • 
  • relative performance evaluation • 
  • options

This paper studies the value of additional performance signals under limited liability. We show that -- contrary to the informativeness principle -- informative signals may have no value, because the payment cannot be adjusted to reflect the signal realization.

We derive new conditions for a signal to have value under limited liability, and study how valuable signals should be incorporated into the contract. In a compensation setting, we show precisely how the signal realization should change the number of vesting options and the option strike price, providing guidance for performance-based vesting. Surprisingly, it may be optimal for more options to vest upon a negative signal of effort. In a financing setting, our results also have implications for whether the debt repayment should be performance sensitive.

Authors

Real name:
Pierre Chaigneau
Real name:
Daniel Gottlieb