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CEO Stock Option Pay & Risk-Taking Investments: Moderating effects of situational factors

Sujin Song and Sungbeen Park are are PhD students at Penn State University; Kyung-A Sun is Assistant Professor at Temple University; and Seoki Lee is Associate Professor at Penn State University.

Restaurant industry has been known for high business risk and strong protections for executives, which give rise to high level of managerial discretion and agency problems (Finkelstein et al., 2009; Guillet & Marttila, 2010). Thus, corporate goverance such as executive compensation is a critical issue in the restaurant industry as a way of motivating executives to take a risk-taking investment to maximize shareholders’ wealth. Considering the high business risk and agency problems in the restaurant industry, the current research investiages how a restaurant firms’ risk-taking investment is influenced by executives’ stock option pay and its interactions with other organizational and individual characteristics.

Building upon the traditional agency theory, we find that CEOs who are heavily paid with stock options are likely to engage in risk-taking investment. However, the link between stock option pay and a firm’s risk-taking investment is weakened by a firm’s prior stock performance, CEO age, and tenure, which supports the prospect theory (Kahneman & Tversky, 1979) and the concept of pay-person interactions (Wowak & Hambrick, 2010). That is, as the firm’s stock performance increases, as a firm has an older CEO, and as a CEO has longer tenure, they tend to avoid taking risky investments.

This study captures a key mechanism behind a restaurant CEO’s risk-taking behaviors by focusing on CEO stock options, which are seen as the most effective tool for motivating executives to take bigger risks (Sanders & Hambrick, 2007). However, our findings support the critical perspective of behavioral theorists that agency theory has a narrow horizon of maximizing shareholder wealth and lack of concern for other constituencies (Sanders, 2001). Thus, we suggest that granting stock options to executives is not a perfect solution to motivate executives to take the risk. Shareholders or board of directors would need to understand their organizational situations and individual factors of executives when contracting the executive pay structure.

References
Finkelstein, S., Hambrick, D. C., & Cannella, A. A. (2009). Strategic leadership: Theory and research on executives, top management teams, and boards. Oxford University Press, USA.
Guillet, B. D., & Mattila, A. S. (2010). A descriptive examination of corporate governance in the hospitality industry. International Journal of Hospitality Management, 29(4), 677-684.
Kahneman, D. & Tversky, A. (1979). Prospect theory, an analysis of decision under risk, Econometrica, 47(2), 263-292.
Sanders, W. G. (2001). Behavioral responses of CEOs to stock ownership and stock option pay. Academy of Management Journal, 44(3), 477-492.
Sanders, W. G., & Hambrick, D. C. (2007). Swinging for the fences: The effects of CEO stock options on company risk taking and performance. Academy of Management Journal, 50(5), 1055-1078.
Wowak, A. J., & Hambrick, D. C. (2010). A model of person-pay interaction: how executives vary in their responses to compensation arrangements. Strategic Management Journal, 31(8), 803-821.

 

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