Benefits of Broad-Based Option Pay

Future wage payments drive a wedge between total firm output and the output share received by the firm s owners, thus potentially distorting strategic decisions by the firm s owners such as, e.g., whether to continue the firm, sell it, or shut it down. Using an optimal contracting approach, we show that the unique optimal firm-wide employee compensation scheme from this perspective is a broad-based option plan. Broad-based option pay minimizes the firm s expected future wage payments in states of nature where the firm is only marginally profitable, thus making continuation as attractive as possible in precisely those states of nature where, e.g., a high fixed wage would lead the firm s owners to inefficiently exit