Incentives for CEOs to Make Decisions

We ask how CEOs should be optimally compensated to make value-maximizing decisions that may cost them their jobs. Examples are the decision to shut down the firm, to give up resistance against a sale or takeover, or to acknowledge failure of the firm’s current business strategy, thus allowing the board to hire a new CEO with a different managerial vision. We find that the CEO’s optimal compensation package consists of cash, options grants, and severance pay. As opportunities to reallocate firm assets become more valuable, shareholders must cede substantial rents to the CEO in the form of more valuable option grants and severance pay. Restrictions on either the size or the form of the CEO’s pay may destroy value and impede efficient reallocations of assets across industries. ∗We thank seminar participants at the London School of Economics, HEC, CEMFI, as well as Claudio Michelacci, Rafael Repullo, Javier Suarez, and Eloic Peyrache for valuable comments. †INSEAD, London School of Economics, and CEPR. Address: INSEAD, Department of Finance, Boulevard de Constance, 77305 Fontainebleau Cedex, France. Email: [email protected]. ‡New York University and CEPR. Address: Department of Finance, Stern School of Business, New York University, 44 West Fourth Street, Suite 9-190, New York, NY 10012. Email: [email protected].