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 :

December 20 2018
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. For example, we show how the number of vesting options and the option strike price should depend on performance signals, providing guidance for performance-based vesting. Surprisingly, it may be optimal for more options to vest upon a negative signal of effort. Our results also have implications for the optimality of pay for luck and whether debt should be performance sensitive.

Authors

Real name: 
Pierre Chaigneau
Real name: 
Daniel Gottlieb